Goldman, Morgan Stanley Likely To Face Steeper Capital Requirements

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The country’s biggest banking groups will most likely need to work on additional measures to shore up their balance sheets over coming quarters, as the Federal Reserve is eyeing capital requirements for “too big to fail” banks that are much stricter than those proposed under the current Basel III norms. [1] Looking to deter U.S. systemically important financial institutions (SIFIs) from growing any bigger, the Fed is considering the option of increasing the capital surcharge on some of these banks by as much as 2 percentage points. While the move directly impacts each of the country’s eight largest banks which figure in the Financial Stability Board’s (FSB) list of global systemically important banks (G-SIBs), the Fed’s decision to impose a heavier surcharge on banks that rely on funding with a term less than one year from other large institutions for their day-to-day operations puts Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) right in the middle of the issue.  This is because both banks rely less on retail deposits to run their investment-banking focused business models.

See Full Analysis for: Bank of AmericaGoldman SachsJPMorgan ChaseMorgan StanleyCitigroup Wells FargoBNY MellonState Street

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The Tier I common capital ratio as defined by the Basel committee has been the de facto standard for comparing the financial health of banks across the world for more than two decades since it was standardized as a part of Basel I norms. And it remains the primary capital ratio that banks have to achieve under the impending Basel III implementation. An important revision made by international regulators as a part of the Basel III norms was to classify the G-SIBs into separate categories in terms of their business models, geographic diversification as well as quality of asset base. This allows financial regulators to define different capital requirements for these banks, with the bigger, more complex banks attracting stricter capital requirements.

The eight U.S. banks currently fall under the following categories or “buckets” according to the latest Basel III classification:

Bucket Capital Surcharge G-SIBs
4 2.5% JPMorgan Chase
3 2.0% Citigroup
2 1.5% Bank of America
Bank of New York Mellon
Goldman Sachs
Morgan Stanley
1 1.0% State Street
Wells Fargo

In other words, JPMorgan Chase (NYSE:JPM) (which is in Bucket 4) has to hold an additional 2.5% in capital above the 7% base minimum – or a total of 9.5%. But the Fed’s latest decision to impose a surcharge over and above what is prescribed by the Basel committee in the classification above could mean that the minimum Tier 1 capital ratio could be as high as 11.5%. The investment banks are at a larger risk of facing additional capital requirements because of the Fed’s view that banks with more exposure to short-term debt should be forced to hold more capital. The view in itself likely comes from the fact that excessive dependence on short-term debt securities is an important factor that helped drive Lehman Brothers to bankruptcy and pushed several other financial giants to the brink during the economic downturn of 2008.

We believe that over coming weeks the Fed will propose a structure in which:

  • Wells Fargo and the custody banks (BNY Mellon and State Street) will see a minimum capital surcharge (if any at all) due to their stable business models
  • The diversified banking groups Citigroup, JPMorgan and Bank of America will attract a moderate capital surcharge of around 1% – bringing their total Tier 1 capital ratio requirement to no higher than 10.5%
  • Investment banks Goldman Sachs and Morgan Stanley will have to adhere to the highest capital surcharge of 1.5-2% – bringing their total Tier 1 capital ratio requirement to around 10%

If the Fed clears the higher capital requirements, then the banks affected will have to to shrink their balance sheets by offloading more of their capital-intensive units and they will also be forced to hold back on dividends over subsequent quarters. The banks may also have to issue additional equity in the near future – diluting shareholders’ interests. The chart below captures our forecast for Goldman Sachs’ dividend payout in the years to come. You can see how a slower increase in the payout ratio will impact Goldman’s share value by making changes to it.

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Notes:
  1. Fed to Hit Biggest U.S. Banks With Tougher Capital Surcharge, The Wall Street Journal, Sept 9 2014 []