The Big Idea
Bank capital and capital markets
Steven Abrahams | August 18, 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.
Page 493 of regulators’ new bank capital proposal includes a striking estimate of its impact on bank balance sheets. Banks’ risk-weighted assets would go up under the proposal by $2.2 trillion, and required capital would go up, too. But the proposal attributes $880 billion of those assets, or 40% of the increase, to trading activities. The capital needed to run a broker dealer on a bank balance sheet would rise sharply under the new proposal, even though the impact on markets is unknown. As the proposal itself says, “The overall effect of higher capital requirements on market-making activity and market liquidity remains a research question needing further study.”
Capital required for market, operational and counterparty risk
The rise in risk-weighted assets on page 493 shows the estimated impact of regulators’ pivot to a new capital framework, the Basel III endgame, in the works for years. The framework broadly does a couple of things:
- Expands the calculation of risk-weighted assets by adding operational and counterparty, or CVA, risk to the existing categories of credit and market risk
- Changes the rules for calculating risk-weighted assets attributable to credit and market risk—standardizing them for the most part and allowing model estimates only in limited circumstances—and adds new rules for operational and counterparty risk
- Applies the rules to a wider set of banks, broadly including banks with $100 billion or more in assets
Applied to balance sheets at the end of 2021, risk-weighted assets under the Basel III proposal would reflect credit, market, operational and counterparty risk (Exhibit 1). Notably, risk-weighted assets attributable to credit—the largest block—decline by 3% under the proposed rules while assets attributable to market risk rise 77% for the largest banks and 69% for remaining large banks. Assets attributable to operational and counterparty risk are entirely new.
Exhibit 1: Risk-weighted assets rise substantially under the proposed rules
The proposal does not detail where those risks sit in specific lines of bank business, but on page 500 it estimates that trading activities increase risk-weighted assets under the Basel III rules by $880 billion.
Banks need to hold capital to support risk-weighted assets, of course. All else equal, $100 in risk-weighted assets requires $8 of capital. To support $880 billion of additional risk-weighted assets, a broker dealer would need $70.4 billion of capital. Of that capital, at least 4.5% would need to be common equity Tier I, which includes common equity, retained earnings and the accumulated-other-comprehensive-income (AOCI) account. An additional 1.5% of the capital could be other Tier I capital, typically preferred stock. And another 2% of the capital could be Tier II, typically subordinated debt. These forms of capital would replace less expensive debt funding, and since interest expense is deductible, the lower leverage would increase each bank’s tax bill, too.
The Federal Reserve Board staff, in its memo on the proposal, emphasized that “Capital requirements for trading activities are estimated to increase substantially, more than doubling for some firms, though the ultimate impact would vary substantially depending on firms’ individual business activities and use of internal models.”
Clear concern among regulators
The heavy capital proposed for making markets has clearly attracted attention from the regulators themselves and may not have their full support.
“The proposed very large increase in risk-weighted assets for market risk overall requires us to assess the risk that large US banks could reduce their activities in this area,” Fed Chair Powell noted in a statement released on the day the Fed Board approved the proposal, “threatening a decline in liquidity in critical markets and a movement of some of these activities into the shadow banking sector.”
Fed Governor Michelle Bowman, also in a statement released on the day the Board approved the proposal, wrote “Today’s proposal argues that the increase in capital requirements for trading activities could enhance market liquidity, especially during times of stress.” But she expressed some skepticism. “I am interested to hear from the public whether this would be the case. I am concerned that claims of this nature fail to appreciate the predictable effects of the proposal: higher costs, less availability, and increased concentration as firms without sufficient scale exit certain markets.”
Fed Governor Christopher Waller focused on the capital that bank trading groups already hold because of current stress tests, which would continue. “It is not clear to me why our large banks should face a further roughly 70 percent hike in market risk capital requirements, on top of the existing post-crisis requirements to address risks in the trading book, including market risk capital requirements plus the stress test,” Waller said in a statement on the day of Fed Board approval. “And I worry that doing so could discourage those banks from engaging in certain market making activities, which could impede market functioning.”
Regulators’ view of the potential impact of higher capital for trading
The proposal itself on pages 500 and 501 sketches potential pluses and minuses of having banks hold more capital for making markets:
- Bank-affiliated broker dealers could become more resilient, improving market liquidity especially in times of stress
- The scaling up of capital with risk could discourage excessive risk-taking in normal times, such as the positions that triggered large losses in from 2007 through 2009
- Resilience and stability could support a larger role for bank-affiliated dealers in making markets and could enhance financial stability
- On the other hand, high capital requirements could reduce incentives to engage in certain market-making activities and impair liquidity
The proposal acknowledges that empirical evidence of the impact of capital on market liquidity is limited and mixed. Some studies compare allocation of capital to market-making across banks and nonbanks as bank capital requirements rose after the Global Financial Crisis. Some studies find bank dealers committed less capital (here) while other find no compelling evidence (here).
Choices for broker dealers
The Basel III endgame proposal, if implemented with no changes to other US bank regulations, would mark a significant natural experiment on the interplay between bank capital and market-making. Broker dealers operating on bank balance sheets would face a few choices:
- Continue in the same lines of business and try to cover the higher cost of capital through wider bid-ask, higher fees, more fees, possibly requirements that clients use commercial banking services or a combination these approaches
- Reduce expenses to help cover the higher cost of capital
- Get out of capital-intensive trading business where the firm has insufficient pricing power or cannot cut costs enough to provide fair return to equity
Without a detailed before-and-after picture of an existing broker dealer balance sheet under the proposed rules, it is hard to know exactly the types of trading that would show up as capital-intensive. This will likely become clearer in coming months as broker dealers work through their own balance sheets. The proposal broadly describes risk factors, factor sensitivities and correlation scenarios that will go into determining risk-weighted assets. A broad reading of the proposal suggests capital would go disproportionately to:
- Desks that showed extreme losses in past episodes of market stress
- Desks that take the most spread or basis risk, or option or convexity risk
- Desks that hold the most illiquid assets
- Desks where risks cannot be captured by a formal model
Issues of market structure
One of the obvious issues that shows up in the remarks by Powell, Bowman and Waller is market structure.
Powell notes the risk that more trading activity could move to nonbanks willing to run with less capital. This could put pricing pressure on bank broker dealers, reducing return on capital and possibly encouraging further limits on bank market-making.
Bowman focuses instead on banks that choose to stay in the same lines of business with the market power to extract more revenue and reduce costs, and with the scale to pay for the infrastructure needed to administer the new rules. She sees the risk of more concentration of bank trading activity.
Waller highlights the risk that nonbank market makers with less capital and less stable funding could leave or get forced out of the markets during stress. He argues that higher capital requirements for trading activities at banks might produce a more stable banking system but a less stable financial system.
Choices for investors
As for investors, a shift in the market-making landscape would almost certainly require revisiting trading counterparties with an eye toward cost, capacity, flexibility, stability and quality of service. That is probably nothing new. But the names and the mix of banks and nonbanks may change.
Comments by November 30
Regulators have asked for comments by November 30, and given the scope, complexity and unknown impact of the proposed rules, it promises to be a robust response. And given the apparent concern by senior regulators, there seems to be plenty of room for change.
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The view in rates
OIS forward rates broadly see no more hikes from the fed and roughly steady rates through March. The same forwards then anticipate 100 bp of cuts from March to December 2024. The market is probably missing one more hike in November. Other than the missing hike, the market at this point is pricing a fair path. The Fed may hold rates high into July next year and then cut 100 bp by December, but that amounts to a small difference in the long run. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.
Other key market levels:
- Fed RRP balances closed Friday at $1.82 trillion, up $46 billion from a week ago. The shortest Treasury bills trade at yields just below the RRP rate of 5.30%, and most bank deposits yield well below RRP. RRP is getting the cash.
- Setting on 3-month term SOFR traded Friday at 538 bp, up 2 bp over the last week.
- Further out the curve, the 2-year note closed Friday at 4.94%, up 5 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.25%, up 10 bp in the last week. Much of the rise in 10-year yields came after hints of a shift in Japan’s yield curve control and the Treasury announcement of heavy supply ahead. With inflation likely to drift down and growth likely to slow through this year and next—shaping the Fed path—fundamental fair value on the 10-year note for now is closer to 3.50%.
- The Treasury yield curve closed Friday afternoon with 2s10s at -69, steeper by 5 bp over the last week. Expect 2s10s to reflatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -1 bp, steeper by 3 bp over the last week.
- Breakeven 10-year inflation traded Friday at 231 bp, lower by 6 bp over the last week. The 10-year real rate finished the week at 195 bp, up by 17 bp in the last week.
The view in spreads
The Bloomberg investment grade cash corporate bond index OAS closed Friday at 149 bp, wider by 3 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 182 bp, wider by 8 bp in the last week. Par 30-year MBS TOAS closed Friday at 77 bp, wider by 7 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month but trending wider.
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.