To The Moon

In my post US Banks To Fall As More Q2 Earnings Are Out? dated 17 Jul 2023, I have briefly mentioned about the “new” capital requirement.

To read, click on above “blue link” ok. Show some love, like that post.. Thanks.

It’s only been 2 weeks since.

Now it seems like it’s about to be cast in stone (see below).

On Thu, 24 Jul - the FDIC (US Banks’ Regulator) voted 3-2 to move the proposal forward.

FDIC is seeking comments on the regulation, with the intent of commencing the transition in July 2025.

When implemented, it would impact shareholders, private equity firms and clients.

More importantly, banks will be impacted directly because they would have “less available resources” to generate profits.

This stringent capital requirements arose in the aftermath of the regional banking crisis earlier in March this year.

To declare that Regional Banks are out of the woods (crisis) is an understatement.

Critics said it could crimp shareholder dividends and buybacks for years to come.

While regulators said big banks have ample time & capital to comply without hurting either.

FDIC Chair, Martin Gruenberg added that “as the size and complexity of a financial institution increases, there are more opportunities for operational risk to emerge “.

Operational risk exposures have and continue to be a persistent and growing risk for financial institutions.

The introduction of a simpler, standardized risk calculation is an important feature of the new requirement.

In the face of Banks say, and FDIC Regulator says - who is “right”?

Who Will Be Affected?

• Accordingly, the new requirement is part of FDIC’s ongoing effort to get US banks to adopt the Basel III framework (an international banking standards).

• The Basel III framework seeks to fix the scenario of an undercapitalized and over-leveraged banking system, that could be vulnerable to future banking crises.

• The Basel framework was formulated & adopted in the wake of the 2008 Financial crisis.

• Banks with >$100 Billion in assets will be subjected to this requirement.

• For US, approximately 30 US-based lenders, including regional banks like $M&T Bank(MTB)$ and $KeyCorp(KEY)$ would be included.

• This is why I say that Regional banks are not yet out of the woods.

• At first glance, seems like community banks would be excluded.

• However, with another back-to-back rule stating that (a) institutions with greater than $5 Billion in tradable assets and liabilities, OR (b) institutions with trading assets > 10% of total assets - would need to comply to the new requirement too.

Would this translate to more than the initial 30 US-based lenders ultimately being affected?

What Will The Proposed Rule Do?

Some of the features are:

• Stricter capital requirements.

• A simpler & standardized framework for calculating risk.

• Changes to “models-based regulatory” approach that FDIC deems as “volatile” as it could generate inaccurate estimates of risk & lack of transparency.

• A 2016 study by the European Central Bank (ECB) found that “models-based” approach tends to underestimate default risk by up to a percentage point.

Impact on Banks, Shareholders and Consumers

• According to Bloomberg Intelligence, “although the rules likely would not be implemented for several years, when they do, it could erase the > $100 Billion that big banks have accumulated in excess capital over the past decade, and it will take the banks years to recover the losses”.

• It sounds very “dramatic”, but no one really knows for sure how things will play out eventually.

• On the other hand, if the requirement is legislated, there might be an immediate reaction on “affected” banks stock prices.

• Not to mention immediate effects on shareholders as banks would be forced to limit share buybacks and dividend payouts as they start to set aside the capital required.

• Other concerns include (i) additional capital requirements would result in banks passing on some of those costs to consumers, (ii) small businesses might be affected by this new rule as banks would have less to lend out, (iii) higher capital requirements definitely increase the cost of credit, that is bad for the economy.

Who Will Benefit?

• Hedge funds and private equity asset managers eg. $Blackstone Group LP(BX)$ and $Apollo Global Management LLC(APO)$ could stand to gain.

• They would not be burdened by the same capital requirements.

• They could lure away shareholders and clients from big banks.

• Asset managers could also benefit when affected banks might sell or divest (a) certain loans and (b) other assets, creating an opportunity for less-regulated funds and private-credit firms to step in to fill the void.

• Paraphasing $JPMorgan Chase(JPM)$ CEO, Jamie Dimon’s off-the-cuff remarks during Q2 2023 earnings call when he was asked about the impending rule proposal - “They’re (Hedge funds & Asset managers) dancing in the streets “.

My Viewpoint:

• I am tilted towards more discipline versus more “free play” for the simple reason that when a bank crisis occurs, it’s the common man in the street that stands to lose, not the high-flying CEO, CFO etc…

• At the same time, I am confident that the Mega cap banks are “innovative” enough to find other or new ways of generating profits for themselves.

• If the new rule could prevent another bank run or other unforeseen crises, this could not be totally bad altogether, right?

• Investors in banking stocks (like myself) will have to follow this news piece closely. This is because bank stocks are on a “high” now.

• If the new rule goes ahead, an immediate correction to banks’ stock prices would be unavoidable, and without emotions (attached) - quickly sell and wait for a good “re-entry” price.

• Do you think the new capital requirement rule will be enforced?

• Do you think bank stock prices will be “hammered” if the new requirement is enforced?

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