The Big Idea

Proposed bank regs raise capital, reduce rate risk

Tom O'Hara, CFA | July 28, 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.

Banks look likely to hold more capital, take less interest rate risk and hold fewer mortgage loans under rules proposed Thursday by regulators. The proposals target banks with assets of $100 billion or more, although these banks will almost certainly push back before the November 30 deadline for comments. The proposal did not include changes to liquidity requirements or held-to-maturity accounts expected by some bankers, so regulators’ 1,089-page tome may have a few glints of silver lining.

New rules that were largely expected

The proposal from the Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation included a few widely expected proposals:

A new approach to setting asset risk weights and required capital. For larger banks using advanced approach models to calculate asset risk-weightings (RW), the regulators are pushing these banks toward a more standardized RW. Banks would need to calculate RW under two approaches: (1) the expanded risk-based approach considering credit risk, equity risk, operational risk, market risk and credit valuation adjustments, and (2) the standardized approach, and the bank would be required to use the higher of the two risk-weighted assets (RWA) from these methodologies. The expanded RWA will be phased in over several years beginning in 2025 (Exhibit 1).

This is perhaps the most meaningful component of changes expected to raise capital requirements for the largest banks, which will need to sell loans, raise new capital or do both to comply with these proposals.

Exhibit 1: Percentage of expanded total risk-weighted assets

Source: Regulatory capital rule: Amendments applicable to large banking organizations and to banking organizations with significant trading activity, July 27, 2023. Fed, OCC, FDIC, Santander US Capital Markets

Higher risk weights for residential mortgages. Regulators propose to increase RW for residential mortgages from the current 50% for all mortgages to a loan-to-value (LTV) based range of 40% to 90%, increasing RWA for mortgage holdings with LTV greater than 80% (Exhibit 2).

This should push more residential mortgage origination to non-bank originators and result in more securitization, as banks will be less inclined to hold mortgage loans in portfolio and incur the higher RW.

Exhibit 2: Proposed risk weights for residential real estate exposures that are not dependent on the cash flows of the real estate

More attention to interest rate risk. The proposed rules end the ability of banks with assets between $100 billion and $700 billion to exclude or filter out Accumulated Other Comprehensive Income (AOCI) from regulatory capital. This new approach would phase in over the next few years beginning in 2025 (Exhibit 3).

These banks will want to minimize the regulatory capital volatility that will come with the removal of the AOCI filter and will therefore need to keep the duration of their available-for-sale (AFS) securities portfolios shorter going forward. This should result in less demand for longer duration securities such as residential pass-throughs. Banks have recently represented about one-third of the demand for this product, so, all else equal, expect pass-through spreads to widen.

Exhibit 3: Percentage applicable to transition AOCI adjustment amount

Positive surprises: expected changes that do not appear in the proposal

The regulators’ proposals also left out some changes widely expected by banks:

Uninsured deposit run-off assumptions for Liquidity Coverage Ratio (LCR) calculations do not increase.
Banks with assets between $100 billion and $700 billion, currently subject to only 70% to 85% of LCR as well as the Net Stable Funding Ratio (NSFR) do not need to comply with 100% of both ratios.
No increased stress testing for banks with assets between $100 billion and $700 billion.
No limitations on held-to-maturity designation for securities portfolios.

Negative surprises: unexpected proposed changes

But the proposals included some unexpected changes to capital for commercial real estate and for the overall balance sheet.

Higher risk weights for commercial real estate. RW for some commercial real estate (CRE) exposures could go higher based on LTV for commercial mortgages, at a time when capitalization rates are increasing and values are declining (Exhibit 4).

Banks, already concerned with the credit risk for their CRE portfolios, will have one more reason to scale back.

Exhibit 4: Proposed risk weights for CRE exposures that are dependent on the cash flows of the real estate

More deductions from regulatory capital. Regulatory capital deductions for intangible and higher-risk assets such as mortgage-servicing rights (MSR) will increase for banks with assets between $100 billion and $700 billion. Currently, those banks only need to deduct from common equity tier 1 capital (CET1) the amount of any such item that individually exceeds 25%, but the proposal would hold those banks to the same standard as banks with more than $700 billion, which are required to deduct from capital any such item that exceeds 10%.

For example, a bank is this size range with MSR equal to 15% of CET1 has a RW of 250% on the entire MSR portfolio. Going forward, that bank would have an RW of 250% on the first 10% of the portfolio and 1,250% on the additional 5%. While MSR ownership is now generally dominated by non-bank servicers, often with a bank as the sub-servicer and not the owner of the asset, this will push that dynamic even further.

A new capital charge. Banks with assets between $100 billion and $250 billion will now be subject to the supplemental leverage ratio, which is tier 1 capital divided by total leverage exposure.

The minimum requirement here is 3%, so banks close to the limit will need to raise capital, decrease leverage or both.

A new capital buffer. Banks with assets between $100 billion and $250 billion will now be subject to the countercyclical capital buffer. The countercyclical capital buffer is used to increase the resilience of the financial system by increasing capital requirements during a period of elevated risk of above-normal losses.

If the buffer is implemented and a bank falls below the minimum 2.5%, then banks are constrained on capital distributions such as dividends and share buybacks, as well as bonus payments.

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

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