Will Yellen's Tough Capital Rules Hurt Bank Stocks?

Big U.S. banks will perhaps have to meet additional capital requirements, beyond the minimum international standards. The banking regulator is contemplating to impose additional liquidity requirements and make several changes to the current stress testing methodology and process for the U.S. Globally Systematically Important Banks (GSIBs).

At a House of Representatives Financial Services Committee hearing, Fed Chair Janet Yellen provided some insights into the changes in the annual stress tests that the central bank is currently considering. Yellen further stated that these changes are expected to direct the regulations toward a more risk-sensitive and firm-specific approach. This, in turn, would result in a significant aggregate increase in capital requirements for the eight largest U.S. banks that are categorized as GSIBs.

These banks are Bank of America (NYSE:BAC) Corporation (NYSE:C) , The Bank of New York Mellon Corporation (NYSE:BK) , Citigroup Inc. (NYSE:C) , The Goldman Sachs Group, Inc. (NYSE:GS) , JPMorgan Chase & Co. (NYSE:JPM) , Morgan Stanley (NYSE:MS) , State Street Corporation (NYSE:STT) and Wells Fargo & Company (NYSE:WFC) .

Proposals Being Considered

In her testimony, Yellen proposed that the large banking organizations will now have to adhere to single counterparty credit limits, which have been designed to guard against the buildup of excessive concentrations of credit risk. Further, together with the other federal banking agencies, she also proposed a Net Stable Funding Ratio, which would require banks to maintain a minimum level of stable funding, relative to the liquidity of their assets over a one-year period.

In addition, Yellen proposed the integration of the Comprehensive Capital Analysis and Review (CCAR) program with the regulatory capital framework. Hence, the regulatory capital rules will now include a firm-specific and risk-based capital surcharge for each GSIBs and a uniform capital conservation buffer requirement above the regulatory capital minimum for all firms.

Yellen further added, “Each firm's buffer requirement would be set equal to the decline in its common equity tier 1 capital ratio in the supervisory stress test. The buffer requirement would be floored at 2.5 percent of risk-weighted assets, the current level of the capital conservation buffer, to avoid any reduction in the stringency of the regulatory capital rules. We call this idea the ‘stress capital buffer’ and it would effectively move the stress test to the center of our regulatory capital framework.”

For the GSIBs, this move would result in higher capital requirements. On the other hand, the move is not expected to toughen the requirements for the 25 large banking firms that are subject to CCAR, but are not GSIBs. Also, the change is not expected to have any impact on community banks or other firms, which have less than $50 billion in assets.

In addition, Yellen proposed to make certain changes to the stress test assumptions. Under the current CCAR program, a firm's capital adequacy is assessed by assuming that the firm continues to make its baseline capital distributions over the stress test's two-year planning horizon. However, Yellen now proposes firms to add one year of planned dividends to their stress capital buffer requirement, because they are generally more reluctant to reduce dividends than share buybacks. Nonetheless, Yellen seeks public input before adopting these changes.

Bottom Line

The primary aim behind the Fed’s proposal for additional capital surcharge is to make big banks more resilient to future financial shocks. Further, as most banks have raised substantial amount of capital since the financial crisis, they would not find this additional surcharge rule difficult to comply with.

However, failure to meet the proposed capital requirement will lead to restrictions on the GSIBs’ capital deployment activities. Also, we believe that the additional capital cushion will likely lower the banks’ lending ability, thereby putting further pressure on revenues.

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