Last week, the Wall Street Journal reported that the Fed and two other U.S. banking regulators are going to significantly reduce a planned increase in capital requirements for the country's large banks.
As a reminder, the regulators were planning a 16% increase in capital levels and a 20% increase in RWAs (risk-weighted assets) for the banks with total assets of more than $100B. These changes should have improved the banks’ financial resilience and prepared them to better absorb potential losses.
In truth, even this would have been a mild increase, given the current state of the credit cycle in the U.S. Credit quality metrics of most lending products in the system are deteriorating quite rapidly, while exposure of large banks to shadow banking intermediaries and extremely risky structured products grows at double-digit rates. Yet, for some reasons, the Fed and other regulators have decided to significantly reduce planned increases in capital requirements.
We believe that the key reason is that the powerful banking lobby, led by JPMorgan (JPM), Goldman Sachs (GS), Citigroup (C), and other large banks, launched an unprecedented campaign against these changes.
The Bank Policy Institute, a trade group representing JPM and other large banks, reportedly hired one of the country’s top trial lawyers and was planning to sue the Fed if the Fed did introduce those changes in capital requirements. Suing the Fed for its regulatory initiatives sounds unbelievable. Yet, the banking lobby was ready to do that.
According to Reuters, Goldman recruited dozens of small business owners from all over the country and escorted them to meet senators in Washington. Goldman Sachs told them to urge the senators to ask the Fed to reconsider the proposed changes in capital requirements. The meetings were arranged, paid for, and scripted by Goldman Sachs; each small business owner had an agenda timed down to the minute.
It is also somewhat interesting that Goldman is so worried about small business loans, as the Fed was not planning to apply these new capital rules to banks with assets of less than $100B, which are granting the majority of small business loans in the country.
The banking lobby launched an ad campaign on TV, and these ads were aired even during high-profile NFL games. The ad started by suggesting that every American has an opinion about the Basel III regulation, when very few even knew about the issue:
“In America, people disagree on just about everything—except the Fed’s new rules that would tighten capital markets.”
Here is also an amusing quote from Bloomberg:
“I’ve been watching football all my life and have been working on banking issues all of my career,” said Klein, a former US Treasury official who follows financial regulations at the Brookings Institution, a think tank in Washington. “I have never seen people spend money to reach the generic American football watcher about a technical bank capital issue coming out of Basel.”
It looks like the efforts of the banking lobby were successful. The obvious question here is why large banks launched such a fierce lobbying campaign? At the end of the day, CEOs of large banks are constantly saying that their banks are well-capitalized, and a well-capitalized bank can easily meet those mild increases in capital requirements.
First, given how the balance sheets of large banks look now, those statements about “well-capitalized large banks” are too optimistic - to put it mildly. If you follow our banking work, you know that we have published a lot of articles on various issues that are currently sitting on larger banks’ balance sheets.
Second, there is a clear conflict of interests between the banks’ senior management and the banks’ counterparties who are interested in its financial stability. Yes, we are talking now mainly about you - retail depositors. Bonus payments from senior management are almost always tied to one indicator, which is a return on equity (ROE). The initial changes would have very likely lowered the ROEs of large banks due to higher capital bases and lower degrees of risk-taking. Lower ROEs mean lower bonus payouts, and these payouts are usually much higher than the annual salaries of top management.
A return on equity is an important metric for a bank, but there are other metrics, some of which are even more important for a bank in a crisis environment. For example, a return on equity is only one of the 20 metrics that we are using to evaluate a bank. But, as we can see, the goals of senior management do not seem to be aligned with those of depositors.
Another point is that there is no personal liability for a bank failure. This is the reason senior management at large US banks is taking so much risk on their balance sheets. High-risk banking activities increase ROEs in a growing economy and bull markets, and, as a result, senior management gets their bonuses. If a bank fails, then a worst-case scenario for senior management is that they lose their jobs. As such, only regulators can prevent senior management from excessive risk-taking.
It is quite amusing to consider that large banks worry that the new capital rules would affect their ability to grant residential mortgage loans and business loans. They have already mostly refocused their lending activities from home loans and business loans to much riskier credit segments. According to the Fed, residential real estate loans grew by 3.3% YoY in 2023, while commercial and industrial loans were flat YoY. At the same time, credit cards, the riskiest segment in retail lending, grew by about 15% YoY in 2023. Moreover, loans to shadow banking intermediaries, which are a complete black box even for regulators, grew by 11% YoY. Here is a quote from our article on shadow banking loans:
Loans to shadow banking companies have shown impressive growth over the past decade. As the chart below shows, these loans skyrocketed by more than 200%, from $324 billion as of January 2015 to more than $1 trillion as of January 2024. In other words, those loans now account for almost half of the sector’s total equity. By comparison, total loans and leases in bank credit have increased by less than 60% over the same time period.
The biggest concern is that shadow banking loans have been regulated very lightly, as usually these loans finance very complex deals and transactions, including leveraged buyouts or startup-related financing. As such, these loans are a black box not only to the public but to regulators as well.
Acting head of the Office of the Comptroller of the Currency, Michael Hsu, recently told the Financial Times that “he thought the lightly regulated lenders were pushing banks into lower-quality and higher-risk loans.”
As a reminder, almost 70% of these loans to shadow banking intermediaries were granted by the 25 U.S. largest banks.
In addition, large banks have significantly increased their exposure to collateralized loan obligations (CLOs), one of the riskiest structured products, which we have also discussed in our previous articles. As of the end of 2023, JPM had $60B in CLOs, while Citi and Wells Fargo (WFC) had $29.7B and $29.4B, respectively.
Bottom line
We believe this is another reminder that you should not rely on the banking regulators to protect your bank deposits because, as we see, they are under significant pressure from the very powerful banking lobby.
So, I want to take this opportunity to remind you that we have reviewed many larger banks in our public articles. But I must warn you: The substance of that analysis is not looking too good for the future of the larger banks in the United States, and you can read about them in the prior articles we have written.
Moreover, if you believe that the banking issues have been addressed, I think that New York Community Bank (NYCB) is reminding us that we have likely only seen the tip of the iceberg. We were also able to identify the exact reasons in a public article which caused SVB to fail, well before anyone even considered these issues. And I can assure you that they have not been resolved. It's now only a matter of time before the rest of the market begins to take notice. By then, it will likely be too late for many bank deposit holders.
At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.
You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles, which outline why such reliance will not be as prudent as you may believe in the coming years, one of the main reasons being the banking industry’s desired move towards bail-ins. (And, if you do not know what a bail-in is, I suggest you read our prior articles.)
It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. Feel free to use our due diligence methodology outlined here.
This article, as well as Saferbankingresearch.com, is a combination of efforts between Avi Gilburt and Renaissance Research, which has been covering U.S., European, LatAm, and CEEMEA banking stocks for more than 15 years.
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