American Banks Set To Be Choked By New Regulations

American Banks Set To Be Choked By New Regulations

The biggest banks in the US are going to face even stricter regulations than those outlined in Basel III, which could reduce their earnings even further

Published: September 10, 2014 at 1:29 pm ESTBy: Troy Kuhn

The largest banks in the US – JPMorgan Chase & Co. (JPM), Bank of America Corp (BAC), Citigroup Inc (C), and Wells Fargo & Co (WFC) – find themselves in the line of fire, as the Federal Reserve and US Senators push for further regulations. The banks will be subjected to regulations that are tougher than the Basel III requirements for capital adequacy and liquidity.

Fed Governor, Daniel Tarullo, said that the Federal Reserve is planning to implement liquidity requirements that will be more onerous than the Basel III requirements. This regulation will protect the systemically important banks in the event of an economic shock.

Investors finally responded to the news yesterday, as the share prices of Bank of America, Goldman Sachs Group Inc (GS), JPMorgan, Citigroup, and Morgan Stanley (MS) all fell. Investors fear that the new regulations will result in a declining return on equity due to the enforcement of a higher capital surcharge.

The biggest losers on the imposition of a higher capital surcharge will be the big banks. Lawmakers made clear distinctions between big banks that are considered too big to fail and other financial firms at the Senate Banking Committee hearing yesterday.

A higher capital surcharge is the next step in the measures taken to reduce the risk of big financial institutions. According to the new rules, banks will be required to hold higher portions of safe and liquid assets to aid their operations in the short-term, in case of a potential credit crunch. American banks, which rely heavily on volatile short term-sources of funding such as overnight loans, will be penalized by the Federal Reserve. The Fed had earlier made it mandatory for banks to hold ultra-safe assets that can instantly be sold for funds in times of financial stress.

As banks start to acquire more ultra-safe assets, such as Treasurys, their returns are expected to slide further, as interest rates are already at an all-time low. JPMorgan – the largest bank in the US by total assets – had a return on tangible equity slightly below 10 percent, whereas Goldman Sachs had a return on tangible equity of around 11%, as per their last quarterly filings. However, if the Federal Reserve imposes a regulatory system similar to that in the UK, the banks’ return on tangible equity could fall drastically.

Currently, all the big banks in the US have their capital ratios above the threshold levels of 8% and 9.5%. However, banks on the other side of the Atlantic maintain much higher capital ratios – usually more than 10 percent. Due to higher capital ratio requirements in the UK, the return on tangible equity for Barclays PLC (ADR) (BCS) was only 2%.

The capital surcharge which the Federal Reserve will impose on the banks will increase the minimum level of high quality assets that big banks are required to hold. American banks that are considered too big to fail will have to increase their ultra-safe high quality capital assets by 1-2.5 percentage points. The exact increase in high quality capital will be calculated according to the relative riskiness of a bank.

When the surcharge was proposed, banks all over the world initially railed against it, calling it unnecessary as it will reduce their capabilities to lend. It is expected that banks in the US will argue a similar case.