Fed Governors Signal Bigger Bank Capital Requirements Looming

Daniel Tarullo and Jerome Powell say action would affect eight systemically important Banks

By Ryan Tracy and David Reilly

 Fed governor Daniel Tarullo said the Fed is likely to require the largest U.S. banks to maintain an amount of capital under stress equal to a ‘surcharge’ the Fed required those banks to hold under normal times last year. Photo: for The Wall Street Journal

WASHINGTON—The biggest American banks will likely have to bulk up their balance sheets further to protect against possible financial shocks, Federal Reserve officials said Thursday.
The new requirements could crimp profitability and dividend payouts at those firms, while increasing pressure on them to shrink.

Fed governors Daniel Tarullo and Jerome Powell, in separate public comments, said the central bank would probably decide to require eight of the largest U.S. banks to maintain more equity to pass the central bank’s annual “stress tests,” exams designed after the financial crisis to measure the ability of banks to weather a severe downturn.

“I have not reached any conclusion that a particular bank needs to be broken up or anything like that,” Mr. Powell said at a banking conference. The point is to “raise capital requirements to the point at which it becomes a question that banks have to ask themselves.”

The change is likely to be proposed formally later this year and isn’t expected to take effect before 2018—though banks will have to start adjusting their finances sooner to phase in the changes required to meet those standards.

“That’s not good for us,” J.P. Morgan Chase JPM 0.18 % & Co. Chief Executive Officer James Dimon said Thursday at a financial-investor conference in response to the comments. The bank is the country’s largest by assets and would be hardest hit by any changes. “Hopefully we’ll be able to adjust,” Mr. Dimon said. “We put a lot of power, money, people on to get these things right as we modify our business practices to meet the new rules.”

J.P. Morgan says current rules require the bank during normal times to maintain an additional capital buffer of 3.5% of certain assets, compared with banks not considered systemic. That requirement previously was 4.5% before the firm made some moves to shrink over the past year.

Citigroup Inc., Bank of America Corp. BAC 0.54 % and others face similar, though less strict, capital “surcharges,” which are tailored to a bank’s size, complexity and links to other firms, aiming to capture their impact on the financial system. The other banks covered are Goldman Sachs, Morgan Stanley, MS -0.76 % Wells Fargo WFC 0.22 % & Co., State Street Corp. STT 0.06 % and Bank of New York Mellon Corp. BK -0.21 % 
Meanwhile, the Fed said Thursday it would announce results of its annual stress tests on June 23 and June 29, first on how banks performed on the stress tests and then whether it has approved the capital plans of the largest banks, including whether they will be able to increase dividends and share buybacks. This year, 33 of the largest U.S. banks are taking the tests.

The proposal is the latest salvo in a battle between banks and regulators since the financial crisis over how much the largest banks need to reorient their business models to protect against the possibilities of big losses and another taxpayer bailout. Wall Street argues the banks have done enough already to guard against another crisis and that any further tightening risks undermining the vitality of the financial system.

“It’s a tax on banking,” Goldman Sachs Group Inc. GS -0.43 % Chief Economist Steven Strongin said Thursday at a banking conference, referring broadly to new rules that he said go beyond what would have been required to prevent the 2008 crisis. “This hurts those individuals that are dependent on banking services,” such as midsize companies, small businesses and low-income consumers, he said.

Regulators say they are still not convinced the banks have evolved sufficiently to reduce the danger that they could destabilize the financial system, by simplifying their sprawling business structures or making themselves smaller. The new capital rules previewed Thursday by Messrs. Tarullo and Powell weren’t prompted by any new warning signs that have emerged in the financial system but rather are part of the Fed’s gradual process of weighing new safeguards since the crisis.

“Effectively, this will be a significant increase in capital,” Mr. Tarullo said on Bloomberg
television. He said the extra capital was necessary in case big banks face a danger that the Fed’s annual stress test didn’t predict.

Mr. Powell said that the Fed’s move would go beyond existing rules to make big banks “fully internalize the risk” they pose to the economy. While some critics want to break up these large banks, the Fed has instead sought to force them to tighten capital and other rules they must follow, effectively taxing their size. The rules have sent a clear message to big banks: Staying large will be costly.

Mr. Powell also said the benefits of such rules are likely to outweigh the risk that they would hamper the smooth functioning of markets, by forcing banks to pull back from their market-making role. “I don’t believe that it will have a significant negative effect on liquidity,” Mr. Powell said of the Fed’s next move.

The specific change that Messrs. Tarullo and Powell previewed Thursday involves taking the higher capital requirements big banks now face during normal times—the “surcharge” for being big—and forcing them to meet those standards during periods of stress as well. That effectively forces those institutions to hold even more capital on their books throughout the business cycle, as capital levels would likely fall during a recession when losses would rise. Fed officials have long said they were considering such a requirement, but these were the most explicit comments confirming that they are likely to impose that rule.

The potential inclusion of these new surcharges in future stress tests has been a concern of both bank executives and investors for some time. The Fed-administered tests have become a constraint for banks and many executives now manage with these exercises in mind. That isn’t surprising given the tests’ importance in banks’ getting the Fed’s blessing on paying dividends and buying back stock.

But it also means banks are constantly trying to adjust to a shifting regulatory environment.

The stress tests are something of a black box—intentionally designed by the Fed as such to keep banks from trying to game them. So that keeps banks off balance, even as they spend millions and hire thousands on compliance efforts meant to satisfy regulators and pass the tests.

Bank-stock investors seemed to take the news in stride. Shares of the biggest banks were mixed Thursday as the broader market fluctuated during the day. That in part reflects the opaque nature of the stress tests, which are difficult for analysts to model. Shares of the biggest banks are still mostly down year to date, even as the S&P 500 has eked out a small gain. So, investors are less likely to punish them further for rules that could take some time to kick in.

The rule covers the eight banks considered crucial to the functioning of the U.S. financial system. The Fed in 2015 said those banks would have to maintain a surcharge of extra capital beyond what other banks hold, a rule that will fully take effect in 2019. Boosting such requirements forces banks to fund themselves with more equity to offset their debt, reducing the gains they can receive by using borrowed money, or leverage. This is a shift that can make certain business lines less profitable.

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