Big banks haven't even received the results of their latest stress tests yet, but it's already time to start stressing about future ones, especially for investors.
Federal Reserve Governor Daniel Tarullo said on Thursday that the eight global systemically important U.S. banks would most likely have to meet stricter capital requirements in future tests. He told Bloomberg Television that he's confident that the Fed will "change the post-stress requirements for the amount of capital that banks need to have even after absorbing the losses that are hypothesized in the stress scenario."
Fed Governor Jerome Powell also discussed the plan on Thursday, saying it will mean surcharges of 1 percent to 4.5 percent of risk-weighted assets that the eight big banks face will most likely be incorporated into the post-stress minimum requirements and will lead to a "substantial increase" in capital requirements for the eight largest banks. (Just as a reminder, the Big Eight includes Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo.)
The rationale is to make sure too-big-to-fail banks are well capitalized in the event of a crisis that's beyond the vivid imagination of the doom-and-gloom scenarios outlined in the Fed's stress tests.
"We can't anticipate all things that might happen, there is the unknown unknown," Tarullo said.
There is likely a point when banking regulators risk overreaching in their effort to protect the financial system, when the cure becomes worse than the disease. Are we there yet? Some may argue we've been there for years, while others may argue they haven't reached far enough. In any event, it's hard not to point out that the Fed's point man on regulation is starting to sound like Donald Rumsfeld, who pitched the bright idea of invading Iraq by talking about "known unknowns" and "unknown unknowns."
Regardless, the stock-market mantra of "don't fight the Fed" is truer nowhere more than in the banking sector. And in this case, the Fed governors have made it clear whose side the central bank is on: the little guy. Smaller U.S. banks, which have complained that they've been burdened by costs to comply with the regulations that have come in the wake of a crisis caused by their bigger rivals, will be getting a break in future stress tests. Tarullo said the relief would come in the qualitative analyses of the banks’ stress tests, not quantitative capital requirements. Powell made it clear smaller is better: “You can either have much higher levels of capital, in which case you’d be much less likely to fail, or you can take steps to reduce your systemic footprint, in which case there would be less risk to the financial system."
How big of a deal this will be to the too-big-to-fail banks is anyone's guess. A lot can change between now and then, considering the spectrum of opinions from presidential candidates still in the race ranges from breaking up big banks to repealing Dodd-Frank. And Tarullo's talk of "a significant increase in capital" and offsets from other elements of the stress tests leaves a lot of wiggle room.
However, this talk of the need for tougher capital requirements comes at an interesting time -- just weeks before the results of the latest rounds of stress tests are expected to be released. Maybe it signals the Fed wasn't pleased with how the tests came out. Another theory could be that the banks all passed their stress tests, and the Fed is taking a tough stance now so that it doesn't look like an easy grader later this month. Regardless, prudential investing would suggest dialing back any expectations for the size of dividend increases and share buybacks from the Big Eight.
In other words, the governors just added a big fat "known unknown" for investors in bank stocks.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Updates throughout with comments from Federal Reserve Governor Jerome Powell.)
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