Those ‘New’ Bank Capital Rules? Old, Slow-Moving News

While banking system stress has quieted, financial headlines haven’t, with many still fearing further fallout and others on the watch for new regulations aimed at strengthening the sector. Being on the lookout is sensible enough, considering tough new rules could strain lending, ratcheting up economic risks. So when The Wall Street Journal reported Monday that certain US banks are set to face a 20% increase to capital requirements, it caught our eye.^[i] But the story fell apart quickly, as a quick look at the context will show. In this case, the regulations discussed are old news—and the fear over them looks like more bark than bite. Banks and markets have long been aware of looming changes and implementation is likely to take years. Surprise power looks minimal.

So, what is changing?

Let us first briefly recap the jargon-laden regulations in question. The forthcoming changes, known as Basel IV or Basel III endgame, are revisions to Basel III, the regulatory regime born in the aftermath of 2007 – 2009’s Global Financial Crisis. With a goal of strengthening guardrails throughout the global banking system, Basel III raised capital requirements, toughened annual stress tests and added an extra layer of capital and liquidity buffer hurdles for the biggest banks.

While scant on details, the Journal article briefly touches on a few of the higher-profile aspects of Basel IV. It claims big US banks’ capital requirements could increase by 20%, largely due to an increase in risk-based capital requirements for fee-heavy businesses like trading. Meanwhile, mid-sized banks—those holding between $100 and $750 billion in assets—face tougher regulations resembling their even bigger peers’.

Why we think recent headlines overstate the shifting regulatory dynamics at play in the banking system.

Thing is, the information is largely old news. It isn’t catching banks off guard. The industry has known about some of it for months—the rest for years. Bankers, regulators and investors have discussed the broad Basel IV framework since 2017. If not for pandemic-related regulatory can kicking, they probably would have started implementation last year. Even the alleged 20% capital boost is old news—and it still isn’t a blanket certainty. In 2021, the Fed’s then-Vice Chair for Supervision Randal Quarles stated Basel IV could result in an “up to 20%” increase in big banks’ capital levels.^[ii] Reiterating long-standing information is the opposite of market-moving surprise power.

We do think a sudden, huge increase to capital requirements—or wholesale change to accounting rules—in response to springtime banking tremors would be a potential negative for the economy and markets, depending on its scope, surprise factor and speed of implementation. But Basel IV doesn’t qualify. Not only would proposed regulations undergo a lengthy feedback period, but any finalized rules wouldn’t begin phasing in until 2025, and they wouldn’t be fully implemented until 2027 or later. This gives banks plenty of time to adapt to rule changes and generate capital by retaining earnings or other means, without cutting back on lending. In recent years, the biggest banks’ capital hurdles have steadily inched higher—banks have already demonstrated they can manage these increases while keeping credit flowing.

We see no reason they can’t continue to walk and chew gum at the same time—a sentiment echoed by banks themselves. When Basel III was implemented between 2014 – 2019, banks met tougher regulations and continued lending, despite widespread fears including the Fed’s ending and reversing quantitative easing, nine Fed rate hikes (and three cuts late), trade war rhetoric and a host of other worries. In a recent survey from Piper Sandler of 82 publicly traded bank CFOs, just 15% cited increased regulation as their biggest worry.^[iii] Banks also entered 2023 with robust capital ratios, comfortably above statutory minimums—a figure which likely hasn’t changed all that much, Q1 bank worries notwithstanding.

Exhibit 1: US Tier 1 Capital Ratios Are Well Above Regulatory Minimums

Source: FactSet, as of 6/8/2023. Q2 2010 – Q4 2022 (latest data available).

Finally, the main tidbit of new news—that regulators seem ready to release proposals as soon as this month—is actually quite encouraging. While this may seem counterintuitive, we think regulators’ willingness to release proposals earlier than recently speculated is a vote of confidence in the banking system’s footing—they seemingly don’t see much need to dig deep for additional major changes after the failures of Silicon Valley Bank, Signature Bank and First Republic. US regulators initially appeared set to release Basel IV proposals in March or April, but they postponed this when banking woes erupted. Furthermore, the sooner the proposed rules are known to all, the sooner uncertainty can clear, allowing markets to move on.

Releasing the rules will also help market discover their potential side effects, which we are watching closely. Even well-intentioned regulation often creates unintended consequences, sowing the seeds for future crises. So far, this appears to be a low-probability outcome, given we have seen no mention of either reinstituting reserve requirements or forcing banks to mark Held-to-Maturity assets to market. In our view, both would be counterproductive and potentially freeze credit markets. Forcing banks to mark illiquid, hard-to-value assets they never intended to sell at the most recent market value was also responsible for the negative feedback loop between hedge funds’ mortgage-backed security fire sales and banks’ balance sheets back in 2008. Additionally, heightened regulation often has trade-offs. Higher capital burdens could create modest headwinds to lending in the coming years and allow more loosely regulated private lenders to continue to capture market share. Charlie Munger’s quote, “Show me the incentive and I’ll show you the outcome,” rings true here.

Ultimately, we find the prevailing narrative that better-capitalized banks could have prevented recent events is flawed, yet unsurprising. Flawed, because almost no amount of capital would have backstopped Silicon Valley Bank’s deposit run, especially given its concentrated customer base. Capital is no substitute for confidence. Unsurprising, because it seems regulators always address risk by arguing banks should hold more capital and are wired to respond to turmoil by raising capital requirements across the board, rather than pursuing tailored solutions for the idiosyncratic banking models that went bust. Regardless, a broad view suggests these long-telegraphed, widely expected changes that will take years to implement aren’t exactly a game changer.