The hits just keep coming for midsize banks. After interest rates rocketed from essentially zero to 15-year highs in about a year, 2023 has brought three of the largest bank failures in U.S. history. Just when it seemed that things had calmed down, Moody's and S&P Global issued credit downgrades for multiple banks, announced reviews of others, and issued negative outlooks for even more.
And today, the three main federal regulators jointly proposed a new requirement that U.S. banks below the level of global systemically important banks (G-SIBs) with more than $100 billion in assets would be required to raise and hold more long-term debt as a source of capital to protect against deposit losses.
That group includes Truist Financial, PNC Financial, and Capital One Financial Services Group, all with over $467 billion in assets. Also on the list are large regional banks including Fifth Third Bancorp, Citizens Financial, and M&T Bank, which have over $200 billion in assets, and Regions Financial, with about $155 billion in assets.
Investors may be able to call them the "basically too big to fail" banks.
Banks already facing profit pressures
U.S. banks are generally regulated or have oversight from one of three entities: The Federal Deposit Insurance Corp. (FDIC), the Federal Reserve Board (FRB), and the Office of the Comptroller of the Currency (OCC). Following the failures of Silicon Valley Bank and Signature Bank in March, and the subsequent failure of First Republic Bank in May, it has become more clear that many larger midsize and regional banks may not be as well capitalized as they seemed.
The biggest culprit? Sharply rising interest rates. The quick move from record lows to pre-great-financial-crisis highs is putting more pressure on banks than they have seen in years. Many are facing more competition for deposits, forcing them to increase yields, at a time when many are more encumbered with large amounts of low-yielding fixed-rate mortgages. It's hard to make a buck when you see competitors paying higher yields on deposits than you earn on a large portion of your loan portfolio.
Compounding that profit pressure are the massive paper losses many banks now have in their loan portfolios. Simply put, a bank facing a liquidity crisis would have to realize those massive paper losses if it were forced to sell mortgages it issued or acquired during the ultra-cheap-money years of 2020 through early 2022.
As a result, regulators are concerned that some of these banks simply don't have the capital to make depositors whole in a worst-case scenario.
What exactly are regulators proposing?
In short, regulators are proposing that non-G-SIBs with at least $100 billion in assets would need to have a minimum amount of long-term debt. The idea is that this additional debt would provide capital that would further secure against potential losses by depositors in a bank failure. In addition to the debt requirements, the FRB is proposing these banks also "comply with specified clean holding company requirements akin to those required of GSIBs."
Again, "basically too big to fail."
What's the key driver behind these proposed rules? The failures of the three large regional banks earlier this year were all caused in part by concerns -- and then bank runs -- by depositors in excess of the $250,000 FDIC insured limits. The FDIC acted quickly and made whole all U.S. depositors at both Signature Bank and Silicon Valley Bank, using the "systemic risk exception." But this is not a step it can take every time.
This is about protecting depositors. From the proposal memorandum: "The proposal would improve the resolvability of covered entities and covered IDIs [insured depository institutions] because the LTD [long-term debt] would be available to absorb losses in the event of the failure of a covered entity or covered IDI, and provide the FDIC a broader range of options for resolving a covered IDI."
To put it more succinctly, this is about protecting depositors in a worst-case scenario, and injecting more confidence into these banks, particularly for larger depositors. The debt in question would be subordinate to deposits and to general unsecured creditors. The debtholders would still stand in front of shareholders in line, but behind other creditors, specifically depositors.
The impact for investors
Having to issue more debt in this environment isn't great for banks, particularly the ones regulators are most concerned about. The ones most in need of a confidence-instilling and depositor-protecting capital infusion are likely the ones that are already facing the most profitability headwinds.
Moreover, there's a little bit of putting more responsibility onto debt markets to hold these banks to a higher accountability. Any investor holding this debt would know that it exists to protect depositors, and they would surely put more scrutiny into the business condition of the banks. The same can be said for debt ratings agencies like Moody's, S&P, and Fitch.
Add it all up, and if this proposal goes into effect, the banks it covers will face higher capital costs as a result, and in an environment where they already face pressures on their profits.
That doesn't mean that investors should avoid them: To the contrary, if the market discounts their shares enough to offset both the higher costs that will weigh on profits, they can still make for winning investments. Moreover, if the debt markets do more to hold banks accountable to strong balance sheets, these banks could also become lower-risk going forward.
