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Federal Proposals Would Force Big Financial Firms to Limit Exposure to One Another

Source: WSJ - Victoria McGrane & Dan Fitzpatrick

Posted on 21 Dec 2011

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The biggest U.S. banks will be required to limit their financial ties to one another under new proposed rules aimed at preventing the collapse of one big institution from triggering a larger, cascading crisis.

The net credit exposures between any two of the nation's six largest financial firms, including J.P. Morgan Chase & Co. and Goldman Sachs Group Inc., would be limited to 10% of a company's regulatory capital, under a proposed package of regulations released by the Federal Reserve on Tuesday. Most other firms covered by the rule would be subject to a 25% limit, as required by the Dodd-Frank financial-overhaul law.

The new 10% limit for the biggest firms was unanticipated by the industry and has the potential to scale back the capital-markets businesses of large institutions, analysts said.

"Is this a back-door way to shrink those banks?" said Paul Miller of FBR Capital Markets.

The new Fed rule seeks to reduce the interconnectedness of the U.S. financial system. The 2008 financial crisis showed links among major institutions could destabilize the entire economy—as happened when securities firm Lehman Brothers went down and the U.S. government had to prop up Lehman's rivals.

The credit restrictions are one piece of a tougher set of regulations the Fed drafted to apply to the nation's largest, most complex financial firms. The stricter rules aim to reduce the ability of any single financial giant to damage the financial system and the broader economy, and is one of several ways Dodd-Frank attempts to end the "too big to fail" phenomenon that led to huge taxpayer-funded bailouts.

The result of the new rules is that big U.S. banks could be forced to return to a more traditional banking model that revolves around making loans, said Karen Shaw Petrou, managing partner with Federal Financial Analytics Inc. in Washington, D.C. "It will shrink capital markets and securities lending. If it shrinks this as significantly as I expect, the next question is, 'How profitable is what's left?' "

The limit on interconnectness could also force some banks to lend less to other institutions, said banking lawyer Chip MacDonald with Jones Day in Atlanta. "It could affect the liquidity of the markets generally" as banks reduce their exposures to comply with the rule.

The institutions don't break out that exposure publicly.

The six biggest banks—J.P. Morgan Chase, Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley—declined to comment.

Broadly, the rules apply to all banks with at least $50 billion in assets, as well as any nonbank financial firms such as insurance companies or asset managers that U.S. regulators deem to be a big enough threat to financial stability that they warrant the tougher scrutiny. So far, regulators haven't named any of these other firms.

Complying with the new rules is likely to increase costs to U.S. banks at a time when they are trying to trim expenses in the face of profit-squeezing new regulations, lackluster loan volume and intense competition. The Fed, however, believes the benefits to society of making another financial crisis less likely far outweigh the short-term costs to credit availability and pricing that may result, officials said.

But the broad guidelines "are not enough" to lift the uncertainty dragging down bank stocks, said Gerard Cassidy, banking analyst with RBC Capital Markets. Under the proposal, the eight largest U.S. banks would face a so-called capital surcharge of between 1% and 2.5% of their "risk-weighted assets," above a base-line level, as agreed to by international regulators in Basel, Switzerland. But the proposal doesn't address whether other firms covered by the rule would be required to hold any extra capital.

Fed officials told reporters on a conference call that they haven't decided whether banks smaller than those eight covered by the international agreement should face any surcharge, but if they did, it would be significantly smaller than the lowest 1% limit set under the Basel structure. Federal Reserve Governor Daniel Tarullo said in a November speech that, for those banks, "even if surcharges were to apply, their amounts would be quite modest."

The package of rules also sets stricter liquidity and leverage requirements on systemically important firms, and, analysts say, takes a very prescriptive approach to regulating covered companies. Firms must submit to annual stress tests supervised by the Fed, which will make at least some of the results public.

The surprise for smaller banks with $10 billion-$50 billion in assets, which generally aren't the target of the new rules, is that they will now have to conduct an annual stress test as well as establish a risk committee. "That is a really bad idea," because it adds further burden to being a small bank, said John Kanas, the chairman and chief executive of BankUnited Inc., with just more than $10 billion in assets. "Yet another little piece of our profitability will eke out the bottom of the door."

The 173-page Fed proposal also sets out a series of "triggers" meant to signal the firm is running into trouble. A firm that trips any of these early-warning measures would face a series of remedies designed to shore it up, including limits to growth, capital distributions and executive compensation as well as requirements to raise capital or sell assets.

Financial firms and other members of the public have until March 31 to file comments with the Fed, at which point the central bank could make changes before finalizing the package. It isn't clear when the central bank will issue a final rule, but most of the requirements would take effect one year after that date.