The country’s biggest banking groups will have to continue working on their capital structures to meet the stringent leverage ratio requirements laid out for them by the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency (OCC) on Tuesday, April 8. ((Joint Release/Agencies Adopt Enhanced Supplementary Leverage Ratio Final Rule and Issue Supplementary Leverage Ratio Notice of Proposed Rulemaking, FDIC Website, Apr 8 2014)) The banks have put in considerable effort in recent years to shore up their balance sheets so that they comply with the Basel III capital requirements, but with the financial regulators raising the bar further with new leverage ratio requirements, these banks will be forced to review their capital plans for this year as well as the next.
The newly proposed rules raise leverage ratio requirements for the eight bank holding companies (BHCs) with more than $700 billion in consolidated total assets or more than $10 trillion in assets under custody, from the currently implemented Basel III level of 3% to 5%. In addition, FDIC-insured bank subsidiaries for all these BHCs will have to maintain a leverage ratio of 6%. The increased levels, combined with the inclusion of additional assets towards the calculation of a bank’s leverage ratio, will mean that these eight banks will need to raise as much as $68 billion in fresh capital to comply with the new rule.  The banks affected are JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), BNY Mellon (NYSE:BK) and State Street (NYSE:STT).
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Why The Shifting Focus From Common Capital Ratio To Leverage Ratio?
The Tier I common capital ratios as defined by the Basel committee have been the de facto standard for comparing the financial health of banks across the world for more than two decades since they were standardized as a part of Basel I norms. And they remain the primary capital ratio which banks have to achieve under the impending Basel III implementation. However, there still remains one concern among regulators about the Tier I common capital ratio – the ability of banks to tweak the risk-weighed asset base (albeit to a limited extent), as they include extremely complicated assets to value and involve subjectivity in their valuation.
As a counterbalance to this loophole, regulators began shifting their focus to leverage ratios last year – with the simple leverage ratio figuring high on regulators’ minds as a mandatory requirement for the banking giants. Taken in tandem, the common capital ratio and the leverage ratio give a much clearer picture of a bank’s financial stability compared to either of them alone.
What Does A Higher Leverage Ratio Mean For The U.S. Banks?
The country’s financial regulators proposed tighter leverage ratio requirements for the largest, most interconnected U.S. banking organizations in July 2013 and reaffirmed their stand earlier this week by approving the rule. Banks will now have to comply with the new requirements by January 1, 2018 and will also have to report their leverage ratios beginning next year. Failure to do so will allow the regulators to impose restrictions on dividends as well as on share repurchase programs at these bank holding companies, and also to initiate corrective action against their FDIC-insured bank subsidiaries.
The magnitude of the effort required by the banks to comply with the new rule can be gauged by the fact that assuming they maintain their asset base at current levels, the banks will need to raise roughly $68 billion in high-quality, loss-absorbing capital. While the most logical step for most of the banks would be to shrink their balance sheets by offloading more of their capital-intensive units, they could also be forced to hold back on dividends over subsequent quarters. The banks can also consider the option of issuing additional equity in the near future – diluting shareholders’ interests in them – but such a move looks largely unlikely as of now.
The chart below captures our forecast for Goldman Sach’s dividend payout in the years to come. You can see how slower increase in the payout will impact Goldman’s share value by making changes to it.Notes: