Regulatory Reforms Recommended By Treasury Should Benefit Large U.S. Banks

The U.S. Treasury recently released a detailed list of recommendations aimed at the country’s depository system – making it the first of several reports targeting reforms for individual segments of the U.S. financial system. The recommendations presented by the report are largely aimed at reducing restrictions on the banking industry (including considerable dilution of the Volcker Rule), improving the competitiveness of U.S. banks internationally and consolidating the country’s financial regulators.

The recommendations are in large part favorable to the major U.S. banks, with the largest banks expected to gain the most if the changes are implemented. More importantly, Treasury Secretary Steve Mnuchin commented that 80% of the changes detailed in the report can be implemented purely through regulatory changes – requiring only a small portion of the reforms to go through the complicated and uncertain legislative process. This makes it likely that many of the recommendations could be implemented fairly quickly.

Below we highlight the key changes proposed by the U.S. Treasury that directly impact bank operations.

Recommendations Related To Capital Ratio Requirements

Stricter capital requirements since the economic downturn have resulted in all U.S. banks shoring up their balance sheet considerably over recent years. As we pointed out in a recent article, the largest banks have already built a sizable buffer over the target capital ratio figures they need to achieve by 2019. A reduction in the minimum required capital ratios for the banks will help in two ways: firstly, this will free up capital for the banks to lend out to individuals and companies, and secondly, it will allow the banks to return more cash to shareholders through dividends and share repurchases.

• Reevaluate capital and liquidity requirements imposed on U.S. banking giants beyond those deemed necessary under the new Basel Standards: The largest U.S. banks are subject to an additional capital surcharge over the levels recommended by the Basel Committee for global systemically important banks (G-SIBs) – something that the Treasury wants reevaluated. The same goes for the Fed-implemented mandatory minimum debt ratio and minimum debt rule.
• Delay and/or reduce implementation of certain capital ratio requirements: The Treasury recommends limiting the scope of the liquidity coverage ratio (LCR) only to banks with significant international activity – easing the burden of this capital requirement on smaller banks. Additionally, a delay in the implementation of Net Stable Funding Ratio (NSFR) and Fundamental Review of the Trading Book (FRTB) rules in the U.S. is suggested.

Recommendations Related To The Volcker Rule

The Volcker Rule encompasses the most restrictive parts of the Dodd-Frank Act, including a ban on proprietary trading as well as limits of the type and amount of investments banks can make in specific funds. Notably, a bulk of the lobbying efforts by banks against the Dodd-Frank Act were aimed at the Volcker Rule, as the largest U.S. banks generated a sizable amount of profits from now restricted activities well after the economic downturn of 2008. The Treasury recommends significant changes to the Volcker Rule in the interest of market liquidity. Clearly, a dilution in the Volcker Rule will benefit the largest banks the most.

• Do away with Volcker Rule completely for banks with less than $10 billion in assets, and allow prop trading for the larger banks up to a threshold limit defined in terms of trading assets and liabilities: The Volcker Rule’s prop trading ban applies evenly to all banks, but if the recommendation comes into force, then even the largest banks will be able to trade with their own cash as long as they remain within pre-defined limits. To facilitate this, the Treasury also recommends simplifying the definition of proprietary trading, and proposes more lenient compliance requirements for the same. We believe these changes will benefit Goldman Sachs and Morgan Stanley the most, followed by JPMorgan and Bank of America.
• Redefining covered funds: Covered funds refer to hedge funds and private equity funds that now attract restrictions on the amount of their own cash banks can invest in them. Banks cannot invest more than 3% of the fund’s total assets in covered funds, and more leniency in defining these funds should allow banks to increase their stake in some of these funds going forward.

Recommendations Related To The Fed’s Stress Test For Banks

The following recommendations seek to make the Fed’s stress test for banks simpler and more transparent. Overall, these recommendations will reduce the compliance costs that accompany the rigorous tests, while also releasing many mid-to-large sized banks from being a part of them. At the same time, it seems that the proposed changes reduce the overall importance of the stress tests in the banks’ capital planning process.

• Raise the threshold for banks included in the stress tests from $10 billion to $50 billion: The Dodd-Frank Act currently requires all banks with more than $10 billion in total assets to undergo the rigorous annual stress test. An increase in the threshold to $50 billion will reduce the number of bank holding companies covered under the stress test from 115 now to just 43.
• Do away with mid-year stress tests and make annual stress tests simpler: This makes the stress tests easier to implement, with just the base case scenario and the severely adverse scenario forecast in each cycle. One of the recommendations also modifies the forecast period used from nine quarters (currently used) to eight quarters.
• Shift focus away from stress tests’ qualitative assessment: Over the years, the Fed has used the qualitative assessment under the stress tests as the reason for rejecting the capital plans for several banks despite their comfortably clearing the quantitative stress tests. As the qualitative assessment is subjective and less transparent, the report recommends not rejecting plans solely on its basis. This could positively impact the largest banks, as they are much less likely to have their capital plans rejected by the Fed if they are found to be sufficiently capitalized.

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