The Big Idea

Getting ahead of potential bank regulatory change

Tom O'Hara, CFA | June 2, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

With First Republic, Silicon Valley Bank and Signature Bank ranking as the second, third and fourth largest bank failures in US history, respectively, and all occurring within the past few months, it seems unlikely that bank regulators will sit by passively without addressing some of the key issues that led to these failures. Concentrated and uninsured deposits, interest rate risk, and liquidity and funding management are all likely to show up on regulators’ radar over the coming months. Banks may need to fundamentally alter how they manage the main components of their balance sheets to comply with these potential new rules.

On the list of regulatory changes likely in play over the next few months:

• Removal of the AOCI filter for banks with $100 billion or more in assets
• Changes in deposit, liquidity and funding requirements
• More stress testing, more cash, higher risk weights and HTM limits

Removal of AOCI filter for all banks with $100 billion or more in assets

Banks typically account for the majority of their securities portfolio holdings as available-for-sale (AFS), where the securities are marked-to-market and the difference between cost basis and current market value is treated as an adjustment to equity through the account for all other comprehensive income (AOCI).

Currently, Category I Global Systemically Important Banks (G-SIBs) and Category II banks with greater than $700 billion in assets must reflect these AOCI adjustments in their regulatory capital ratios.  Category III banks with assets between $250 billion and $700 billion as well as Category IV banks with assets between $100 billion and $250 billion are currently allowed to opt-out of having these AOCI adjustments reflected in their regulatory capital ratios, and most banks that were allowed to opt-out did so. With the massive Fed rate hikes in this cycle, AFS portfolio values have declined, reducing capital available to meet regulator’s requirements for Category I and II banks but not for Category III and IV banks.  This opt-out arguably allowed these banks to take more interest rate risk without worrying about the impact on regulatory capital.

In recent conversations with bank treasury teams as well as the Bank Policy Institute and other bank lobbying groups, all of which are in regular dialogue with regulators, a change that could be proposed as early as this month is that all banks with $100 billion or more in assets will be required to reflect AOCI adjustments in their reg cap ratios. This would affect 14 banks holding a significant share of banking assets (Exhibit 1). This change would inject more volatility into bank regulatory capital ratios, which may cause the banks to hold more capital as well as look for ways to reduce the volatility of these portfolios.

Exhibit 1:  Banks with total assets of $100 billion to $700 billion

Source: Bloomberg, Santander US Capital Markets

Banks may decide to hold assets with shorter duration, which could include reserves, Treasury bills and notes, short corporate or muni debt as well as short MBS. Of course, this would reduce demand for assets with longer duration.

Banks may face one of their biggest challenges in MBS, where cash flows often run out to 30 years. As of the first quarter of 2023, for the group of banks tracked by Santander US Capital markets, the median holding of agency residential pass-through securities was 32% with only 10% of holdings in agency CMOs.  Bank treasury teams have noted the additional regulatory scrutiny that their CMO holdings receive due to the structured nature and additional complexity of those bonds.  Regulators want to ensure that banks have the sophistication to understand the CMO cash flows in a variety of interest rate scenarios.  Of course, for most bank security portfolio holdings, the structure is designed to shorten duration and reduce interest rate risk.  As regulators become more well-educated on this point, CMO holdings should increase while positions of longer-dated pass-throughs decrease (Exhibit 2).

Exhibit 2:  Short duration bond portfolio alternatives

All spreads are to the interpolated Treasury curve, mid, unless otherwise noted.  *S-spread to the Treasury strip curve.
Source: Bloomberg, Santander US Capital Markets

For positions with longer duration that banks look to maintain, they may decide to hedge the position. With the implementation of FASB ASU 2022-01, portfolio layer hedging is now allowed, which maximizes the amount of principal that can be hedged.  Banks seem likely to lean toward easily hedged securities with a low risk of having the hedge later declared ineffective.

Deposits, liquidity, funding

The recent bank runs were notable given the speed at which they occurred.  Compared to prior bank runs, the 2023 deposit outflow was much more acute, with higher percentages of deposits running for the exits over much shorter time frames (Exhibit 3). The recently failed banks all had much higher percentages of uninsured deposits than average, so expect this metric to receive greater scrutiny going forward.

Aside from corporations being able to pull massive amounts of deposits out of banks quickly, in cases where depositors are concentrated in the same industry such as crypto or technology, there is evidence that those depositors were in regular communication and aware of each other’s activity, further exacerbating the outflow.  Expect industry deposit concentration to receive additional scrutiny.

Exhibit 3: Historical deposit runs

Note: *Figures with asterisks are the expected amount of outflows that were scheduled to go out the next business day, but did not actually occur because the banks were closed.
Source: Rose, J. (2023) “Understanding the Speed and Size of Bank Runs in Historical Comparison,” Economic Synopses, No. 12.

These items may be mechanically addressed in the deposit outflow assumptions used for the Liquidity Coverage Ratio (LCR) calculations.  When deposits are over the insurance limit, they are deemed to be ‘less stable’.  For corporations, the LCR less stable deposit run-off assumption is 40%, and for high net worth depositors, the assumption is 10%.  Expect both of these numbers to be pushed higher in proposed tweaks coming later this year.

Also expected to be proposed this year for LCR, for banks between $250 billion and $700 billion that generally are only subject to 85% of the full LCR calculation and banks between $100 billion and $250 billion subject to 70%, these banks may be subject to the full 100% calculation going forward.

Complementary to the LCR, which measures liquidity over a 30-day period, is the Net Stable Funding Ratio (NSFR), which measures the bank’s stable funding over a 1-year period.  It is also expected to be proposed later this year that banks between $250 billion and $700 billion and banks between $100 billion and $250 billion, currently subject to 85% and 70% NSFR, respectively, will need to go to 100% NSFR.

From an interest rate-risk management perspective, regulators may force banks to assume deposits are less ‘sticky’ and have shorter durations.  This will force a bank’s duration of equity to extend.  Duration of equity assumes that all balance sheet asset items are marked-to-market for given interest rate shocks and is a measure of whether the bank is long or short overall.  An extended duration of equity due to shorter deposit duration assumptions will generally result is greater Economic Value of Equity (EVE) losses for rate shocks both large and small.

Banks can address the interest rate risk of faster outflows from either the asset or liability side of the balance sheet.  On the asset side, the bank may decide to produce fewer fixed rate, longer maturity loans such as traditional residential mortgages, and may opt instead to produce shorter-duration, floating rate loans.  On the residential side, this could include adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs).  As discussed previously for the hedging of long duration securities, banks could comparably hedge longer duration loans by using pay-fixed swaps to convert loan coupons to floating rate.

On the liability side of the balance sheet, banks may address all of these new deposit constraints and liquidity requirements by issuing more debt, both secured and unsecured, with maturities greater than one year and therefore receive an Available Stable Funding (ASF) factor of 100%.  Both of these options are likely to be more expensive than deposits, where the median cost of interest-bearing deposits was 1.72% for the banks tracked by Santander US Capital Markets in the first quarter of 2023.  While this represented an increase of about 60 bp compared to the fourth quarter of 2022, it still only amounts to an industry-wide cumulative beta (the amount of Fed Funds rate increase that is being passed on to depositors) of 40% for this cycle, so deposits are likely to continue getting more expensive over the next few quarters, making other debt options seem more competitive.  Since the recent bank failures, unsecured bank bond spreads have started to recover but are still about 50 bp wide on option-adjusted spread (Exhibit 4).

Exhibit 4: Bank unsecured debt option-adjusted spreads

Source: Bloomberg Investment Grade Banking Index

For secured financing, banks may decide to use securitization treated as a financing from an accounting perspective and not a sale.  Given 500 bp of rate hikes since March of 2022, securitization treated as a sale is likely to result in a loss for most loan types.  Instead, the bank would only sell senior tranches of the capital structure, retaining junior tranches and including other features to show ongoing control of the assets, and continue to account for the loans as Held For Investment (Exhibit 5).  Some banks have securitized in this manner in the past, particularly for auto and credit card loans.

Exhibit 5:  Benefits of securitization as a financing

Source: Santander US Capital Markets (to be confirmed by a bank’s own legal counsel, accountants and regulators)

Both secured and unsecured funding should extend liability duration relative to deposits and help a bank to keep its EVE shocks in check.

Additional potential regulatory requirements

• Stress testing. Banks between $250 billion and $700 billion may be subject to a company-run stress test every year instead of every two years. Banks between $100 billion and $250 billion could now be required to have a company-run stress test, and supervisory-run stress tests would increase in frequency to every year instead of every two years.  Regulators may also announce additional stress testing scenarios this summer, and overall, the regulators are likely to have more testing flexibility going forward and will be less transparent.
• Larger cash holdings. Since the recent bank failures, banks have been reinvesting less and growing their cash positions. This is currently being done voluntarily but in anticipation of new rules making it a requirement.
• Higher risk weighting. Expect to see less variance going forward between a bank’s regulatory capital ratios and their tangible capital ratios, which would be achieved by increasing the risk-weight of currently low risk-weight assets.

HTM limits. Our tracking group saw HTM use increase in 2022 from a median of 35% to 47% throughout the year.  This started to reverse in the first quarter of 2023, mainly due to the removal of Silicon Valley Bank and First Republic from the tracking group, which both had very high HTM allocations.  The median is now 42%, and expect to see continued decreases in this number, voluntarily at least initially, and potentially mandated in the future.