Understanding The Fed’s Proposed Capital Surcharges For The Largest U.S. Banks

Earlier this week, the Federal Reserve detailed the proposed methodology for calculating and implementing capital surcharges for the eight largest U.S. banks. ^[1] The proposal is largely along the lines of how the Financial Stability Board (FSB) treats global systemically important banking organization (GSIBs) since 2011. ^[2] Notably, the eight bank holding companies to which the stricter capital requirements apply also figure in the list of 30 GSIBs released by the FSB in November – namely Bank of America (NYSE:BAC), BNY Mellon (NYSE:BK), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS), State Street (NYSE:STT) and Wells Fargo (NYSE:WFC).

There are two key differences between the way the Fed seeks to impose capital surcharges on these banks compared to the FSB: firstly, the Fed also factors in the proportion of short-term wholesale lending used by a bank while calculating the surcharge (something we detailed in our article Goldman, Morgan Stanley Likely To Face Steeper Capital Requirements) More importantly, the highest surcharge level stands at a much higher 4.5 percentage points in contrast with the 2.5 percentage points level suggested by the FSB. Interestingly, reports suggest that the only bank that sees a capital shortfall under the proposed rule is JPMorgan, which will have to shore up its tier 1 capital by more than $20 billion to meet the new requirement. ^[3]

See Full Analysis for: Bank of America | Goldman Sachs | JPMorgan Chase | Morgan Stanley | Citigroup | Wells Fargo | BNY Mellon | State Street

The Need For Tighter Regulation

Following the global economic recession, the biggest concern among financial regulators has been to ensure that the biggest and most important banks do not buckle under economic pressure the way they did in 2008 when governments were forced to step in and pump in billions of taxpayer dollars to bail-out them out. The concept of a bank acting as the economic backbone of a region or a nation led to the larger idea of banks which are systemically important on the global scale – the GSIBs. The FSB, backed by the G20 nations, is charged with overseeing the financial condition of the world’s largest bank – with specific focus on identifying GSIBs and coming up with ways to making them more robust. As the biggest global banks are extremely diversified in their operations, and as splitting their traditional lending business from the more volatile investment banking operations comes with a long list of issues, the most acceptable solution for the regulators and the banks has been to increase the amount of capital they hold. While the FSB has laid out a basic framework for a capital surcharge in collaboration with the Basel Committee on Banking Supervision (BCBS), the financial regulators for individual country are free to impose additional capital requirements as they deem fit for their country’s financial system.

So What Is This Capital Surcharge All About?

The reason for forcing banks to retain a percent of their total capital sounds simple enough – if the bank has enough capital reserves, then it should be better off in times of an economic crisis. But then, a single surcharge figure will not be suitable for all banks. After all, the ‘biggest’ banks differ from each other radically in terms of their business models, geographical diversification, quality of asset base, and a plethora of such factors. And if one sets an arbitrarily high limit for the capital figure, then the banks would have that much lower cash to lend out to customers – impairing economic development.

The solution came in the form of a minimum capital requirement that should be applicable to all banks, with an additional capital surcharge for individual banks seen as systemically important globally. In September 2010, an accord about the minimum level of capital requirement under the Basel III norms was reached at 7%. And the surcharge proposed for the GSIBs was one of 4 values: 1%, 1.5%, 2% and 2.5%. Like the FSB, the Federal Reserve also categorizes the banks based on four factors: interconnectedness, substitutability, complexity and cross-jurisdictional activity. However, the capital surcharge ranges from 1% to 4.5% – potentially requiring a bank with a 4.5% surcharge to maintain a common equity tier 1 (CET1) ratio of 11.5%.

In our recent article titled Q3 2014 U.S. Banking Roundup: Common Equity Tier 1 Capital Ratios, we highlighted the progress made by the largest U.S. banks in terms of capital ratio requirements over the years. The table below summarizes the data for all eight banks at the end of Q3 2014 and also includes our estimates for the surcharges proposed by the Fed, as the Fed has not released data about individual banks yet. Also, the actual CET1 ratio presented here pro-forma fully phased-in figures at the end of Q3 2014.

Our estimates for the Fed’s surcharge rates are in line with reports that suggest that JPMorgan is the only bank that has a capital shortfall under the proposed norms. As you can see, all banks except for JPMorgan have already met their capital requirements which they are required to adhere to by 2019. Given the fact that JPMorgan reports quarterly earnings in excess of $5 billion, the shortfall should not be an issue for the globally diversified banking group too as it will be able to cover up the reported $20 billion gap by early 2016 even if it sticks to its current dividend payout and share repurchase plan.

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1. Federal Reserve Board proposes rule to further strengthen the capital positions of the largest, most systemically important U.S. bank holding companies, Federal Reserve Website, Dec  9 2014 [↩]
2. FSB publishes the 2014 Update of the G-SIB List, FSB Press Releases, Nov 6 2014 [↩]
3. JPMorgan Chase may need another $20 billion after Fed sets new rule, Fortune, Dec 10 2014 [↩]