For an extended time period, U.S. banks faced the relatively flat yield curve and ultra-low interest rates. Now, when rates have started climbing, banks are faced with another headwind, capital requirements that might double for the largest bank in the U.S..
It seems like the headwinds for the biggest banks never stop blowing.
Capital requirements that might double
The largest banks in the US did not even start celebrating the rising interest rates yet when they were hit with another headwind. The banks were still living on their barely visible net interest rate margins when regulators disclosed that they are under increasing pressure to increase the capital requirements for the largest banks in the country in order to make them safer.
Currently, the banks are required to maintain a capital of 3% of their assets as an international requirement for what’s better known as the simple leverage ratio. Once the new requirements are in place, the largest bank would be required to hold another 3% of their assets as capital, making the simple leverage ratio reach 6%.
Do the banks comply right now?
Let’s look at the six largest banks of the US and see whether they comply with the new requirements right now or not.
None of the largest U.S. banks reports their simple leverage ratio. However, according to the estimates provided by Keefe, Bruyette & Woods Inc and reported by Bloomberg, five of the six largest banks fall below the 6% simple leverage ratio. Only Wells Fargo & Co (NYSE:WFC), with a 7.3% simple leverage ratio, would meet the new requirements if they are enforced today. Both, JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) are at 4.5%.
The Basel committee has also increased its minimum risk-based capital requirements to 8% – 9.5%. Looking at the Tier 1 leverage ratio of the banks, I find out that Wells Fargo & Co (NYSE:WFC) has the most robust capital base. However, all the banks meet the new risk-based requirements. Wells Faro reported a Tier 1 leverage ratio of 9.53% at the end of the first quarter. This is compared to 9.39% and 7.3% for Citigroup Inc (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM), respectively.
Consequences of the new requirements
The new stringent capital requirements are aimed at making the banks safer and ensuring that they will withstand another severe crisis without the help of the US government. Remember, Citigroup Inc (NYSE:C) was bailed out thrice with $45 billion. JPMorgan was given $12 billion, while Wells Fargo & Co (NYSE:WFC) was paid $25 billion.
Since most of the banks are far behind the upcoming capital requirements, they might have to suspend their dividends in order to comply with the new requirements if they are put in force. They will also suffer from lost revenues as more cash will be caught up in the form of capital that is not generating any returns.
Banking stocks are not bought for their dividends. Still, dividends form a large part of the total return investors are looking for. Since the start of the current quarter, Wells Fargo & Co (NYSE:WFC) has gone up 21%, while its current dividend yield is 3%. I believe this yield is safe considering the bank has sufficient capital.
On the other hand, the yields offered by Citigroup Inc (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM) might get hurt. JPMorgan Chase is currently offering a dividend yield of 2.9%, while Citigroup offers a negligible yield of 0.08%. These dividends are highly regulated by the Fed, which might force both these banks to reduce their shareholder distributions further so that more capital can be retained by the banks.
Scrapping the risk-based regulations
There has been a debate going on with regards to the risk-based rules being followed in the U.S. government. FDIC Vice Chairman Thomas Hoeni has proposed against the risk-based regulations and recommends a simple leverage ratio of 10%. If the rule is implemented, JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) would have to suspend their shareholder distributions for another 5 years. A bill in this regard has already been introduced it the U.S. Senate which will require banks to maintain a simple leverage ratio of 15%. However, I believe the bill will not be passed by the senate amid violent reactions by the largest banks.
My opinion
I believe it’s important to make the banks safer if they are not broken into parts. I also believe the larger the banks, the larger the requirement to enable them to withstand another severe crisis with the assistance of the government.
However, the regulations, which require complete scrapping of the current risk-based regulations and demand as high as a 15% simple leverage ratio, will be a nightmare for Citigroup Inc (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM).
It’s not only the largest banks, but the entire economic growth will be hampered when these institutions reduce their lending. Therefore, its important to consider the trade-off between making the banking system safer and hampering economic growth. The 6% simple leverage ratio requirement seems reasonable, and Wells Fargo & Co (NYSE:WFC) is the only large bank that meets this requirement.
Adnan Khan has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Citigroup Inc (NYSE:C), JPMorgan Chase & Co. (NYSE:JPM), and Wells Fargo & Co (NYSE:WFC).
The article Headwinds Never Stop for the Too Big to Fail originally appeared on Fool.com.
Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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