After the collapse of several U.S. banks in March, regulators are assessing what led to the downfall of these banks so quickly and what can be done to prevent such failures. Eventually, I fully expect regulatory changes for some of the larger regional banks.
Whether these changes are implemented by the Biden administration, regulators, or through legislation remains to be seen. It will also be interesting to see which institutions will be subject to them.
While I suspect regulators will focus on regional banks with $100 billion or more in assets, they may also target institutions with $50 billion in assets or more. Here are five big regulatory changes regional banks could see in the future.
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1. More robust liquidity requirements
Currently, banks with less than $250 billion in assets are not subject to the full liquidity coverage ratio (LCR) requirement. The calculation is rather complex, but the LCR requires banks to hold enough highly liquid assets, including cash, securities, common stock, and investment-grade corporate debt, to cover projected deposit outflows over a 30-day period. The required LCR for banks with over $250 billion in assets is 100%.
Banks with under $250 billion in assets must have only enough highly liquid assets to cover 70% of projected 30-day outflows. Eventually, banks with between $100 billion and $250 billion in assets could be required to meet the full LCR requirement.
Regulators could also raise liquidity requirements for even the largest banks. I'm just speculating, but regulators or lawmakers could require the LCR to be shorter than 30 days considering the heightened risk of digital banking and that Silicon Valley Bank saw $42 billion of deposit withdraws in a single day. They could also change how certain assets are weighted under the LCR because, currently, not all highly liquid assets are treated the same, with many being discounted under the calculation.
2. Higher capital requirements
Even though the recent banking crisis had very little to do with how well-capitalized banks were, capital did become an issue if banks had to sell underwater bonds to cover deposit outflows. But in general, I think higher capital requirements were already in the works, with Michael Barr, a well-known believer in higher bank capital requirements, now serving as vice chair of supervision at the Federal Reserve.
The main way the Fed can enforce higher capital requirements is through stress testing it conducts every year. The results of stress testing, an exercise that involves the Fed modeling how bank balance sheets would perform in a severely adverse economic scenario, determine one portion of bank capital requirements.
Some, like Barr, believe stress testing is an inaccurate representation of how banks would perform in a real severely adverse scenario, so stress testing is likely to get tougher in terms of the scenarios applied and the results, which could boost large banks' capital requirements.
Again, I think this is already underway, as many bank CEOs seem unsure about what this year's stress-testing results will look like when released in June. The more capital banks have to hold, the lower their returns will be and the less stock they can buy back.
3. Unrealized bond losses
Currently, banks below $700 billion in assets do not have to incorporate their unrealized bond losses into their regulatory capital requirements. This includes bonds that banks plan to sell before maturity and those they plan to hold until maturity.
The issue has come front and center because the high interest rate environment has put many bank bond portfolios underwater. While these losses will be recouped as rates come down or the bonds mature, if the bonds ever had to be sold while trading at a loss to cover deposit outflows, they would wipe out a substantial amount of shareholder equity.
Now, regulators are contemplating having large regional banks incorporate their available-for-sale unrealized bond losses into their regulatory capital ratios. Bonds do not always trade at a loss -- this is a very unusual environment -- but if applied, this would likely give regional banks less capital flexibility moving forward and require them to hold higher levels of capital.
4. Total loss-absorbing capacity
Another regulation the largest too-big-to-fail banks are subject to that the large regional banks currently are not is called total loss-absorbing capacity (TLAC). TLAC requires banks to maintain certain levels of long-term debt in relation to their risk-weighted assets, such as loans, and their total assets.
TLAC's purpose is to ensure that failing banks can absorb losses with this debt and then potentially convert it into equity to continue providing critical functions and avoid disrupting the safety and soundness of the financial system as the bank winds down.
Regulators had been contemplating TLAC for the larger regional banks prior to the banking crisis, so many have anticipated this change. On PNC Financial's recent earnings call, CEO Bill Demchak said, "TLAC, I think, is a certainty at this point. It's a function of how much it will be and whether it's varied as a function of the size and complexity of a bank."
5. More regulatory work
Large regionals should expect to have more regulatory work if some or all of these changes are implemented. For instance, banks with between $100 billion and $250 billion in assets are currently only required to undergo the Fed's more rigorous Comprehensive Capital Analysis and Review (CCAR) stress testing every other year. This may change to every year.
Finally, following the banking crisis, the Biden administration laid out several regulatory changes it would like to see made to the banking system. One of these would require banks to create comprehensive resolution plans, otherwise known as living wills, which describe how banks can wind down without leading to systemic risk in the broader financial system. All of this work will lead to higher regulatory expenses.
