If the Federal Reserve has its way, big American banks will have to meet additional capital requirement beyond the minimum international standards. The banking regulator is contemplating the levying of additional capital surcharge on the U.S. Globally Systematically Important Banks (:GSIBs).
The proposal will create a methodology that will aid the identification of GSIBs. Once identified, the bank will be subjected to a risk-based additional capital surcharge that would be adjusted according to its systemic risk profile.
Currently, 8 U.S. banks categorized as GSIBs are Bank of America Corporation (BAC), The Bank of New York Mellon Corporation (BK), Citigroup Inc. (C), The Goldman Sachs Group, Inc. (GS), JPMorgan Chase & Co. (JPM), Morgan Stanley (MS), State Street Corporation (STT) and Wells Fargo & Company (WFC).
Proposal
The Fed’s proposal intends to create a tougher version of the international capital rule formulated by the Basel Committee on Banking Supervision. Per the proposal, the GSIBs will calculate the additional capital surcharge based on two methods and higher of the two will be regarded as the additional cushion.
Under the first method, the bank’s size, risk profile, substitutability, interconnectedness and cross-jurisdictional activity will be taken into consideration as per the Basel Committee. The second one will utilize same inputs, but will weigh short-term wholesale funding on a separate scale.
The Fed is of the opinion that the second method will result in significantly higher surcharge. Hence, the banks relying substantially on short-term funding will be required to hold more capital compared to those receiving majority of its funding from deposits.
The estimated capital surcharge under the proposal will range of 1.0 – 4.5% of the GSIB’s total risk-weighted assets (RWAs).The international rule calls for surcharge between 1.0 – 3.5% for GSIBs.
At present, almost all banks are required to meet the common equity capital requirement of 7% of RWAs. The latest surcharge will come over and above this requirement. Therefore, if the proposal is implemented, the highest capital requirement for GSIBs will amount to 11.5% of RWAs.
Roadmap for the Future
The primary aim behind the Fed’s proposal for additional capital surcharge is to make big banks more resilient to future financial shocks. In the words of the Fed’s Chairwoman Janet L. Yellen, “This, in turn, would encourage such firms to reduce their systemic footprint and lessen the threat that their failure could pose to overall financial stability.”
Hence, large banks like JPMorgan, Citigroup and BofA are expected to face the highest capital requirements, unless they shrink their footprints and simplify operations. Additionally, investment banks like Goldman and Morgan Stanley, that depend more on short-term funding, will have to keep aside more capital to meet requirements.
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. Further, the comments of the central bank’s Vice-Chairman Stanley Fischer during a public Fed meeting implied that JPMorgan will be hardest hit by the proposed rule.
Notably, failure to meet the proposed capital requirement will lead to restrictions on the GSIBs’ capital deployment activities and bonus payments. Also, we believe that the additional capital cushion will likely lower the banks’ lending ability, thereby putting further pressure on revenues.
This would invariably lead to lower earnings and squeeze GSIBs’ ability to return capital to their shareholders. Hence, we expect that these banks will have no other option but to shrink or break up their global operations.
The Fed will be receiving comments on the proposal through Feb 28, 2015. The proposal will be phased in beginning Jan 1, 2016, fully effective from Jan 1, 2019.
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