Regional banks face new challenges from debt level requirements

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The U.S. regulators have proposed new rules that would require regional banks to issue more debt and improve their living wills, in order to prevent future failures and protect the public interest. The rules are similar to those that apply to the world’s biggest banks, but they could pose significant challenges for the midsize lenders that are already struggling with low profitability and high competition.

What are the new rules?

The new rules, which were announced on Tuesday by the Treasury Department, Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp., are part of the regulators’ response to the regional banking crisis that flared up in March, ultimately claiming three institutions and damaging the earnings power of many others.

According to a fact sheet released by the FDIC, the rules would require all American banks with at least $100 billion in assets to maintain long-term debt levels equal to 3.5% of average total assets or 6% of risk-weighted assets, whichever is higher. The debt would serve as a buffer to absorb losses in the event of a government seizure, and would also facilitate the resolution of failed banks by providing a source of funding for their successors.

Regional banks face new challenges

The rules would also discourage banks from holding the debt of other lenders, to reduce contagion risk. In addition, the rules would enhance the living wills of regional banks, which are plans that outline how they would wind down their operations in an orderly manner without taxpayer bailouts. The living wills would have to include more details on how regional banks would deal with liquidity, capital, governance and legal issues during a crisis.

How will the rules affect regional banks?

The regulators acknowledged that the rules would create “moderately higher funding costs” for regional banks, as they would have to issue more debt at higher interest rates than their deposits. This could add to the industry’s earnings pressure, after all three major ratings agencies have downgraded the credit ratings of some lenders this year.

However, the regulators also said that the industry would have three years to conform to the new rule once enacted, and that many banks already hold acceptable forms of debt. They estimated that regional banks already have roughly 75% of the debt they would ultimately need to hold.

The regulators also said that the rules would enhance the resiliency and resolvability of regional banks, and reduce the systemic risk posed by their failure. They said that the rules would align with international standards and promote a level playing field among banks of different sizes.

How did regional banks react?

The regional bank stocks fell as the regulators unveiled their plans. The SPDR S&P Regional Banking ETF (KRE), which tracks a basket of regional bank stocks, was down 2.4% on Tuesday. Some analysts said that the rules could hurt the competitiveness and growth prospects of regional banks, especially those that are close to the $100 billion threshold.

Some industry groups also expressed their concerns about the rules. The Bank Policy Institute, which represents large and midsize banks, said that the rules were “unnecessary and duplicative” and that they would “impose significant costs on regional banks and their customers without any commensurate benefit”. The American Bankers Association, which represents banks of all sizes, said that it was “disappointed” by the rules and that it would “urge regulators to reconsider this proposal”.

However, some observers said that the rules were expected and reasonable, given the recent turmoil in regional banking. Minneapolis Federal Reserve President Neel Kashkari, who was the architect of the Troubled Asset Relief Program that helped bail out banks during the 2008 financial crisis, said that he favored getting tougher on regional banks and that he would like to go “significantly further” than the proposed rules. He said that if inflation was not under control and that if the Fed had to raise rates further, regional banks could face more losses and pressures in the future.

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