With changes likely coming to stress testing and the Basel III endgame, banks are facing a rosier outlook on capital requirements than they did two years ago. Just don't expect them to reduce their capital holdings anytime soon.
During an earnings call last month, JPMorgan Chase CEO Jamie Dimon said his bank could shed between $30 billion and $60 billion of equity as a result of expected reforms but, in light of broad political and economic uncertainties, the longtime executive is in no rush to put those funds to work.
"Based upon the environment, the turbulence issues, I like having excess capital," Dimon said. "We are prepared for any environment. And that's so we can serve clients. That's not for any other reason. So, we have plenty of capital and plenty of liquidity to get through whatever the stormy seas are [ahead]."
The economic environment is just one reason banks are reluctant to relinquish their excess equity. Bank advisors and lawyers point to several factors that are likely to keep capital levels above their statutory minimums for the foreseeable future.
Mayra Rodriguez Valladares, a financial risk consultant, said the banking industry's hard push against increased capital requirements under the 2023 Basel endgame proposal has created a misconception about bankers' views toward capital. She said most of her bank clients see the value in being well capitalized and are not especially eager to lower equity levels.
"This idea that they are suddenly going to go skirt the minimum or below, that would be incredibly poor risk management," Rodriguez Valladares said. "I see no evidence at the moment that banks want to drive themselves under."
She added that any move to lower capital levels swiftly would draw the ire of bond investors and ratings agencies, who would likely interpret such a move as a sign of recklessness or distress.
Most banks are well capitalized by the Federal Reserve Board's standards and have been for years. Roughly 99% of banks have met that criteria in every quarter since the third quarter of 2022, according to the Fed's most recent
Most banks also maintain higher levels of common equity Tier 1, or CET1, capital on their balance sheets than they are required to. The six largest banks had an aggregate CET1 ratio of 13.55% at the end of last year, according to data compiled by the Federal Reserve Bank of New York, compared with a minimum level of 11.7%. Banks with fewer than $50 billion of assets had an aggregate CET1 ratio of 15.7%, more than double their regulatory minimum.
Banks maintain excess capital for a variety of reasons, including to protect themselves from balance sheet risks and macroeconomic conditions. But larger banks have made a concerted effort to build equity in recent years as a buffer against future anticipated capital requirements. Since the second quarter of 2022, they have grown their collective CET1 ratio by 15%, compared to the 5% increase by those under $50 billion.
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For the Basel III endgame, officials at the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency have stopped short of pledging to make framework capital neutral, but many in the banking industry expect the implementation to come with no capital increase.
Still, Chen Xu, bank regulatory lawyer with the law firm Debevoise & Plimpton, said banks have other factors to consider when weighing potential capital changes.
"The question is not just whether the new Basel endgame is going to be capital neutral or if requirements are going to go down. If you're a bank trying to make capital planning decisions, the question is: How much can we release to shareholders and how much can we redeploy for better use?" Xu said. "That quantitative question is very difficult to answer until we have, until we see an actual proposal."
The precise changes made to the Fed's stress-testing regime will also influence capital decisions, Xu said.
Kevin Stein, a managing director at the advisory Klaros Group, said banks are also inclined to keep capital levels high in the current environment to help facilitate mergers and acquisitions. He added that this consideration is particularly prevalent in the wake of the government's approval of the Capital One-Discover merger last month.
"There seems to be an openness to transactions that makes sense, and that's one way for banks to use excess capital," Stein said. "The capital isn't just going to go away — banks are going to find a way to put it to work."
Along with mergers and acquisitions, banks can use capital to fund more lending — something that could become more relevant if economic activity picks up in the months ahead — or to absorb losses, should the economy take a turn for the worse. Either way, banks could be disincentivized from shrinking their equity holdings through higher dividends and stock buybacks.
Alison Hashmall, a partner with the law firm Freshfields, noted that capital reforms are tricky and the Basel III endgame has proven to be particularly difficult to navigate. In light of this, she said banks are also wise to hold off on changing the capital levels prematurely.
"There's a risk that nothing happens and the status quo continues for some period of time," Hashmall said. "That's what basically happened in the last administration. It was the priority, they started basically from the beginning and couldn't get it done in four years and it got kicked to the next administration. There is some risk that that could happen again."
