U.S. Fed Faces Difficult Decision on Capital Requirements for Banks

Analysis

U.S. Fed chair Jerome H. Powell: between a rock and a hard place.

Photo by Domenico Fornas / Shutterstock.com.

New regulations on capital requirements for U.S. banks are likely to be announced before the end of June. Corporate finance columnist Les Nemethy says that, while they are highly anticipated, they might impact not only the banking world but also U.S. and global economic performance.

After the 2008 Great Financial Crisis, U.S. banking regulations were tightened, and capital reserve requirements increased; given that, the 2023 bankruptcies of Silicon Valley Bank, Signature Bank, and First Republic Bank surprised many. What went wrong?

Ironically, it was U.S. Treasuries, supposedly a pillar of stability of the financial system, which proved to be the Achilles heel of the banking system. The U.S. Fed recently hiked the Federal Funds target rate from close to zero to more than 5% at breathtaking speed, causing the market value of U.S. Treasuries (and other long-term bonds) to plunge.

U.S. Treasuries not being held to maturity needed to be marked to market, creating huge losses for many banks, including those that went bankrupt.

Whenever banks go bankrupt, it is natural for regulators to re-examine and fine-tune regulations. Changes have been in the air for some time. At a recent Senate Banking Committee meeting on June 22, U.S. Federal Reserve chair Jerome H. Powell announced that some banks might face capital reserve increases of up to 20%.

“The capital requirements will be very, very skewed to the eight largest banks [….]. There may be some increase for other banks. None of this should affect banks under USD 100 billion in assets,” he said. 

The situation reveals certain internal contradictions about why the U.S. Fed is in such a difficult situation.

Poor Targeting of Regulations

First, the change in capital requirements does not seem to target the banks that need it most. It is the smallest (less than USD 100 bln in assets) and mid-sized banks (assets between USD 100 bln and USD 250 bln) that seem to need higher capital requirements the most (although a failure of a bank with assets exceeding USD 250 bln would impact the financial system the most).

The recent instability in the U.S. banking system saw a migration of deposits from smaller to larger banks, so it is the smaller banks that presumably face the most significant stress. (Granted, given that large banks invest a good portion of these increased deposits into Treasuries, they, too, have some increased risk). Nevertheless, it seems that the Fed is applying stricter regulations to those banks with the ability to bear the cost rather than those who need it most.

Macroeconomic Effect of Regulations

The increase in capital requirements will add to several factors already tightening liquidity in the United States when the U.S. economy may already be facing a recession.

(a) The Fed has switched from Quantitative Easing (QE) to Quantitative Tightening (QT), meaning that it is selling off Treasuries, draining the system of liquidity.

(b) During the months prior to the debt ceiling being raised, the cash reserves of the U.S. Treasury were drained. Now that the debt ceiling has been lifted, it is engaged in a massive issuance of Treasuries to replenish its cash reserves, once again draining liquidity from the financial system.

(c) On top of the above would now come an increase in banking reserves. The more money banks hold in reserve, the less they can lend. Given the nature of the fractional reserve system, every additional dollar held back diminishes lending by many dollars. Bank of America estimated that a 100-basis point increase in reserve requirements reduces lending by approximately USD 150 bln. Given that increased reserve requirements will primarily target the eight largest U.S. banks, and these banks do an enormous amount of lending outside America, the ramifications will be global.

You might recall that there are two ways of expanding the money supply: one, a central bank may “print” money, or two, there is bank lending. So, increasing capital reserve requirements actually has the potential to diminish the money supply further.

The timing of these capital reserve increases is also interesting: firstly, because the U.S. and global economies are seeing growth forecasts revised downwards, with the potential of tipping into recession. And secondly, because we are in a period leading up to the U.S. presidential elections.

As Chair Powell recently stated: “With capital standards, it’s always a trade-off. More capital means a more stable, more sound, and more resilient banking system. But it also, at the margin, can mean a little bit less credit availability, and also the price of credit can be affected, and there’s no perfect way to assess that balance.”

While he acknowledges the trade-off, one can only wonder why he downplays the effect on credit availability. Given that monetary tightening is a very recent phenomenon, with little past data or history, it seems that we are in some kind of giant economic and financial experiment where even the U.S. Fed appears to acknowledge its limitations. The Fed is between the proverbial rock and a hard place, groping its way forward.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of June 30, 2023.

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