Big US banks have more than enough capital, or most of them anyway, according to the Federal Reserve’s annual stress tests. Five of the six biggest banks — all apart from Citigroup Inc. — are likely to see their capital requirements lowered for the year ahead after sailing through a tougher test than last year with smaller losses.
Investors, though, are unlikely to get an explosion of dividends and buybacks as the same banks are about to be hit with demands for more capital. In the next few weeks, the Fed will say how it plans to apply the final version of global capital rules. The proposal has been in the works for years; remarkably, the industry has little idea about what the outcome will be. Bank executives are fairly certain that capital requirements are about to go up — but by how much and in what form remain a mystery.
Given that the stress test showed banks are so strong, why bolster capital requirements through other rule changes? The main aim is to make banks more comparable internationally, but regulators also seem to be addressing the long-held suspicion that banks’ internal risk models are too clever for their own good and let them game the system. In the US, a simplified view of risks set by regulators is starting to replace the intricate models created by large financial firms.
The main reason banks are in the dark about the outcome is that the politics, personnel, and market conditions have changed dramatically since regulators began the work. It started under Randal Quarles, the former Fed supervision chief, who was part of a Republican administration more friendly towards banking interests; it finishes under Michael Barr, appointed by a more finance-phobic Democratic White House, and after a string of bank failures.
Executives went from expecting little change in industry-wide capital requirements to thinking an increase of 5% to 10% was possible. Now, they’re worrying it might be more than 10%. Media reports have pegged the rise at more than 20%, but that probably comes from adding up the worst version of the expected proposals and not allowing for potential mitigation. There are lots of moving parts, so tougher rules in one area could be offset by easier treatment in another. The changes are likely to increase the size of bank balance sheets by adjusting how risk is measured. But this growth should be partly countered by lowering the ratio of capital to assets that banks must meet. The Fed’s headline proposal may start out high, but get managed down through technical tweaks during consultations over the next year.
So what’s changing? It’s complicated. Banks work out how much capital they need by measuring the size of their balance sheets based on the riskiness of each asset. For example, a $100 loan to an investment-grade blue chip company gets recorded as smaller than a $100 loan to a highly indebted junk-rated borrower. This also applies to trading positions, and judging the chances of default by counterparties in derivatives trades.
One big change from the Fed will be in sizing trading-desk exposures. Sophisticated banks currently use value-at-risk, which benefits from the tendency of some markets to move in opposite directions to each other. The new standard measures each risk separately, removing this diversification benefit. For Bank of America Corp., Citigroup, Goldman Sachs Group Inc., JPMorgan Chase & Co., and Wells Fargo & Co., this could increase their total risk-weighted assets by between 2% and 8%, according to analysts at Morgan Stanley, who didn’t give an estimate for their own bank.
Another big change adds estimates for the losses that banks can suffer from failures in information-technology systems, human errors or misconduct, collectively known as operational risk. Estimates of the effect of adding this vary wildly: Analysts at Bank of America, for example, say it will increase JPMorgan’s risk-weighted assets by 17%, whereas Morgan Stanley analysts expect the impact for the same bank could be barely half that.
Sophisticated banks already assess operational risks in their internal models, under what’s known as the advanced approach to calculating risk-weighted assets. The Fed will add a simpler version to the risk-weightings it sets under its standardized approach, which smaller banks rely on.
But here’s the rub for the biggest banks: They also have to report their balance sheets using the standardized approach, a calculation that’s become more restrictive for them over time as US regulators have beefed it up. For almost all of the six biggest US banks, risk-weighted assets measured by the standardized approach are now greater than under their own internal models. That means they report lower capital ratios under the former than the latter, so the regulators’ view has more influence over whether they can make payouts to investors. Some analysts say the latest changes will make big banks’ internal modeling permanently irrelevant.
The multibillion-dollar question is how all these changes will translate into capital requirements, which are a percentage of risk-weighted assets. All banks must meet a 4.5% minimum plus a so-called stress capital buffer, derived from the stress tests, which adds at least 2.5%. Goldman Sachs had the largest stress buffer last year at 6.3%. Wednesday’s results suggest most big banks will see this buffer cut and they’ll start reporting their numbers from Friday.
In the future, it could be smaller still for all big banks: It currently includes potential losses from operational risks, but it shouldn’t once those are added to the standardized calculation of assets — otherwise that would penalize lenders twice for the same risks.
Lastly, the biggest lenders face further demands because they are deemed globally systemically important banks. JPMorgan’s GSIB buffer is the largest at 4% of risk-weighted assets, rising to 4.5% next year. Banks hate this – JPMorgan executives regularly call it conceptually flawed. It’s based on size and several other considerations, but given all the other rule changes are going to increase the apparent size — and capital requirements — of big banks anyway, they might finally have an argument for getting the GSIB buffer cut.
The Fed’s proposal on all these changes should land by the middle of July. Capital requirements are going up, but I would bet not by as much as feared. Very large banks are a source of potential instability, but the real-world stress tests of the past few years have shown most are robust. Nevertheless, politics and technical complexity mean investors won’t get a clear view of what it all means for months.
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