The US Fed faces a difficult Decision on Capital Requirements for Banks By Les Nemethy, CEO, Euro-Phoenix M&A Advisors, former World Banker

New regulations on capital requirements for US banks are likely to be announced before the end of June, 2023. They are highly anticipated, and will impact not only the banking world, but also US and global economic performance.

After the 2008 Great Financial Crisis (GFC), US banking regulations were tightened and capital reserve requirements increased; so the 2023 bankruptcies of Silicon Valley Bank, Signature Bank, First Republic Bank surprised many. What went wrong?

Ironically, it was US Treasuries, supposedly a pillar of stability of the financial system, which proved to be the Achilles heel of the banking system. The US Fed recently hiked the Federal Funds target rate from close to zero to over 5% at breathtaking speed, causing the market value of US Treasuries (and other long-term bonds) to plunge. US Treasuries that were not being held to maturity needed to be marked to market, creating huge losses for many banks, including for 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, 2023, US Fed Chair Powell announced that some banks may face capital reserve increases up to 20%: “The capital requirements will be very, very skewed to the eight largest banks…There many be some increase for other banks. None of this should affect banks under $100 billion in assets”.

The situation reveals certain internal contradictions as to why the US Fed is in such a difficult situation:

1, 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 (<100 billion in assets) and medium-sized banks (assets between $100 billion to $250 billion) that seem to need higher capital requirements the most (although a failure of a bank with assets exceeding $250 billion would impact the financial system the most). The recent instability in the US banking system actually saw a migration of deposits from smaller to larger banks, so it is the smaller banks that presumably face the greatest 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.

2, Macroeconomic effect of regulations

The increase in capital requirements will add to a number of factors that are already tightening liquidity in the US, at a time when the US economy may already be facing a recession:
  • the US Fed has switched from Quantitative Easing (QE) to Quantitative Tightening (QT), meaning that it is selling off Treasuries, draining the system of liquidity.
  • During the months prior to the debt ceiling being raised, cash reserves of the US Treasury were drained. Now that the debt ceiling has been lifted, the US Treasury is engaged in a massive issuance of Treasuries to replenish its cash reserves, once again draining liquidity from the financial system.
  • On top of the above would come an increase in banking reserves. The more money banks hold in reserves, the less they can lend. Given the nature of fractional reserve system, every additional dollar in reserves diminishes lending by many dollars. Bank of America estimated that a 100 basis point increase in reserve requirements reduces lending by approximately $150 billion. Given that increased reserve requirements will mostly target the largest eight US banks, and these banks do an enormous amount of lending outside the US, ramifications will be global.

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

The timing of these capital reserve increases is also interesting: first, because the US and global economies are seeing growth forecast revised downwards, with the potential of tipping into recession. And second, because we are in a period leading up to US 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 Chair Powell 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 US Fed seems to acknowledge its limitations. The Fed is between the proverbial rock and hard place, groping its way forward.

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