Tighter Banking Regulations Could Reduce Available Credit

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Proposed regulations for smaller banks show that turmoil in the banking sector may still have an impact on the broader economy.

Key Takeaways

  • New rules proposed for smaller banks would require them to keep more capital on their balance sheets.
  • A number of U.S. banks received ratings downgrades after the announcement, demonstrating the challenge new rules will pose for banks.
  • The requirements would mean smaller banks could have less capital available for lending, which would have an impact on the broader economy.

As equity markets have remained buoyant over the last few months, many investors seem to believe that the challenges in regional banks that became evident in March 2023 have receded. However, increasing capital requirements, a higher cost of funding and rising loan losses continue to challenge business models in this sector.

With new banking regulations on the horizon, pressures on regional banks could have ripple effects on the broader U.S. economy. Here’s what investors need to know.

Higher Standards for Smaller Banks

Banks with total assets of $100 billion or more may be facing new capital requirements, according to proposed rules from the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency. In addition to significantly higher capital requirements, several large-bank requirements would be extended to smaller banks.

For example, at present, if a bank with less than $700 billion in assets is holding securities that lose value but does not sell the securities at the lower price, these “unrealized losses” do not have an impact on the bank’s capital requirements. Under the proposed rules, however, banks with more than $100 billion in total assets would be subject to the same provisions as banks with more than $700 billion in total assets. As a result, the smaller banks would have to declare their unrealized losses. This means that if, for instance, their fixed-income investments lose value as interest rates increase, they will be forced to keep more cash on their balance sheets.

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Separately, the Fed has proposed more rigorous regulations for the eight U.S. global systemically important banks (GSIBs). This would require them to potentially retain greater capital reserves to reduce the chance of bank failure.

It is still early in the rulemaking process for both proposals. They may change after a public comment period, and the rules will be phased in over several years once they are finalized. Nevertheless, they outline the framework of the regulatory regime ahead.

In fact, the obstacles that such changes would pose for the regional banking sector became evident last week, when ratings agency Moody’s Investors Service downgraded its ratings for 10 U.S. banks after the announcement of the proposed regulations. Although the total volume of debt downgraded thus far is relatively small at around $10 billion, Moody’s put an additional six banks on review for possible downgrade and changed the outlooks of 11 banks from stable to negative. Thus, the volume of bank debt facing the prospect of a downgrade is much higher – well over $100 billion.

Regulations and the Real Economy

The impact of tighter regulations goes beyond banks. For instance, banks that experienced larger market-value losses on their securities in 2022 extended less credit to companies looking to borrow, according to recent research from the San Francisco Federal Reserve – and that was when rules around market-value losses applied only to larger banks. If smaller banks are subject to the same requirements, they may have less capital available for lending.

Against this background, the latest Senior Loan Officer Opinion Survey (SLOOS) showed that in the second quarter of 2023, lending standards tightened across nearly all categories for the fourth consecutive quarter. Survey respondents expect further tightening ahead, particularly in commercial real estate, credit cards, and commercial and industrial loans to small firms.

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For the broader economy, these findings show how the evolution of regulatory policy can weigh on credit availability and overall economic growth.

By: Vishy Tirupattur
Originally published at: Morgan Stanley



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