The Federal Reserve Could Redefine ‘Too Big to Fail’

A month after America’s banks witnessed their largest quarterly revenue increase since 2009; Federal Reserve announced that it would increase capital requirements for eight of the largest banks across the country. Under the latest implementation of the Dodd-Frank financial reforms, the new risk-based capital surcharges would apply to systemically important U.S. banks that hold more than $50 billion in consolidated assets. In addition to J.P.

A month after America’s banks witnessed their largest quarterly revenue increase since 2009; Federal Reserve announced that it would increase capital requirements for eight of the largest banks across the country. Under the latest implementation of the Dodd-Frank financial reforms, the new risk-based capital surcharges would apply to systemically important U.S. banks that hold more than $50 billion in consolidated assets. In addition to J.P. Morgan, banks that will have to comply with the new rules are Bank of America Corp., Wells Fargo & Co., Goldman Sachs Group Inc., Morgan Stanley, Bank of New York, Citigroup Inc. and State Street Corp. 

The move taken by Federal Reserve has come before its next round of Annual Stress Tests, which measures how banks will hold up during times of economic turmoil. Banks are swapping tips on how to communicate their data show that they are well cushioned in case of a financial turmoil. It is an effort to make the financial system more cushioned for economic shocks and sudden bank runs. Fed Chairwoman Janet Yellen said the rule “would encourage such firms to reduce their systemic footprint and lessen the threat that their failure could pose to overall financial stability.” A bank with higher capital depends less on borrowed money, which may cease to be available in times of stress. This announcement could hurt firms Morgan Stanley and Goldman Sachs that rely more on short-term market funding in their balance sheets. It is clear that the biggest impact of this news will be on JP Morgan Chase & Co. since it is the largest bank by assets in the nation.  

The term ‘Too Big to Fail’

U.S. Congressman Stewart McKinney in a 1984 Congressional hearing popularized the term “too big to fail”. Two decades later, this term seemed more familiar due to the mega-bank failures. ‘Too big to fail’ is a clear concept asserting that certain financial concerns are too large and well connected to fall apart and incase this occurs, the government should step in to bail them out. Despite the name, too-big-to-fail has not always been based on size alone since smaller firms that are highly interconnected or otherwise considered key have also enjoyed implicit protection. Many argue that giving financial support to big institutions can raise an alarm to the ailing economy instead of curing it since it encourages ‘moral hazard’. The so-called “too big to fail” lending institutions can make risky loans that will pay handsomely if the investment turns out well but will be bailed out by the taxpayers’ money if the investment turns out badly. According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last 20 years, all were resolved by bailouts at the taxpayers’ expense.

What to expect with Fed’s announcement?  

For Banks

The Fed’s announcement could lead to divestment, which means that mega banks could shrink into smaller units to set aside more capital to meet the condition.  This in turn will reduce systemic risk and lessen the impact that big banks could have on the financial system’s stability during their failure.  If there were no divestment, then big banks would be compelled to maintain capital requirements that make them more resilient to shocks. Systemic risk is always a worry during a financial crisis and increasing capital requirements will address the issue. After the last financial crisis, big banks managed to raise billions of dollars of new capital so this announcement might not be that difficult to comply with given the specific time frame. Exact requirements for individual banks are unknown, but eight banks would have to raise a total of $21 billion in additional capital. With the Fed’s capital requirement, banks will be disadvantaged internationally since it is a more rigid version of an international rule formulated by the Basel Committee on Banking Supervision, a global bank regulation body.  This is not a surprise since the Fed always viewed Basel III as flawed as it gives a lot of margin to banks as to risks are measured.  Under the current Basel rules, large banks are subject to a base requirement that states that their capital must be equivalent to 7 percent of their assets, measured according to their riskiness.  

For shareholders

With higher capital, banks would require more funding (through trading and lending) from shareholders. The shareholders would only remain invested if their financial returns were not lowered due to a higher capital requirement. However, if this does not happen, the banks’ share could underperform in which case it might choose to shrink.  In estimation by Mike May, a bank analyst at brokerage firm CSLA, shareholders of a large bank expect its annual earnings to be equivalent to 10% of its capital. Therefore, being big and complex and being bailed out from taxpayers’ money might not be that simple with this new rule. So big bank shareholders may need to change their expectations when it comes to returns on capital. 

Today, finance is so well connected that shrinkage of financial institutions, where none is ‘too big to fail’, seems impossible. Despite the name, too-big-to-fail has not always been based on size alone since smaller firms that are highly interconnected or otherwise considered key, have also enjoyed implicit protection. This step by Federal Reserve has definitely raised the bar for the big banks that were under the notion that they were ‘too big to fail’ making them more responsible towards taxpayers’ money especially in case of an economic downturn.