Authored by Steen Jakobsen via his TradingFloor.com blog,
This week’s biggest news is not the Nonfarm Payrolls, or the European Central Bank or even Portugal’s government falling. No – this week’s big deal is the openness with which the Federal Reserve is preparing a major margin call on the too-big-to-fail banks in the US.
This has been a long time coming since the introduction of the Dodd-Frank law back in 2010 but it is a game changer. Remember all macro paradigm shifts come from policy impulses, often mistakes.
Fed approves step one in a three step plan
Under the final rule, minimum requirements will increase for both the quantity and quality of capital held by banking organisations. Consistent with the international Basel framework, the rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5 percent and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from four percent to six percent and includes a minimum leverage ratio of four percent for all banking organisations. In addition, for the largest, most internationally-active banking organisations, the final rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures. (See the press release here)
I know you are thinking: Wow, this is the most interesting thing I have seen in years 🙂 but alas it is – because it is in fact a major margin call on the US holding banks.
Note how this adoption is only the first set of a series of new rules. Let me introduce you to: Daniel Tarullo, The Federal Reserve Governor in charge of regulation after the implementation of the Dodd-Frank law in 2010. (As a consequence of Dodd-Frank, the Fed got a permanent regulatory governor.)
I had nothing else to do so I read his latest speeches which are surprisingly clear (considering that he’s a policy guy).
Governor Daniel K. Tarullo At the Peterson Institute for International Economics, Washington, D.C.
The speech considers the “additional charges” which are coming and today’s Basel III was only item number one:
First, the basic prudential framework for banking organisations is being considerably strengthened, both internationally and domestically. Central to this effort are the Basel III changes to capital standards, which create a new requirement for a minimum common equity capital ratio. This new standard requires substantial increases in both the quality and quantity of the loss-absorbing capital that allows a firm to remain a viable financial intermediary. Basel III also established for the first time an international minimum leverage ratio which, unlike the traditional US leverage requirement, takes account of off-balance-sheet items.
Second, a series of reforms have been targeted at the larger financial firms that are more likely to be of systemic importance. When fully implemented, these measures will have formed a distinct regulatory and supervisory structure on top of generally applicable prudential regulations and supervisory requirements. The governing principle for this new set of rules is that larger institutions should be subject to more exacting regulatory and supervisory requirements, which should become progressively stricter as the systemic importance of a firm increases.
This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special regulations applicable with increasing stringency to large banking organizations. Under this authority, the Federal Reserve will impose capital surcharges on the eight large US banking organizations identified in the Basel Committee agreement for additional capital requirements on banking organisations of global systemic importance. The size of surcharge will vary depending on the relative systemic importance of the bank. Other rules to be applied under Section 165—including counterparty credit risk limits, stress testing, and the quantitative short-term liquidity requirements included in the internationally-negotiated Liquidity Coverage Ratio (LCR)—will apply only to large institutions, in some cases with stricter standards for firms of greatest systemic importance.
An important, related reform in Dodd-Frank was the creation of orderly liquidation authority, under which the Federal Deposit Insurance Corporation can impose losses on a failed systemic institution’s shareholders and creditors and replace its management, while avoiding runs and preserving the operations of the sound, functioning parts of the firm. This authority gives the government a real alternative to the Hobson’s choice of bailout or disorderly bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under development in other countries, and international consultations are underway to plan for cooperative efforts to resolve multinational financial firms.
A third set of reforms has been aimed at strengthening financial markets generally, without regard to the status of relevant market actors as regulated or systemically important. The greatest focus, as mandated under Titles VII and VIII of Dodd-Frank, has been on making derivatives markets safer through requiring central clearing for derivatives that can be standardised and creating margin requirements for derivatives that continue to be written and traded outside of central clearing facilities. The relevant US agencies are working with their international counterparts to produce an international arrangement that will harmonise these requirements so as to promote both global financial stability and competitive parity. In addition, eight financial market utilities engaged in important payment, clearing, and settlement activities have been designated by the Financial Stability Oversight Council as systemically important and, thus, will now be subject to enhanced supervision.
A margin call is coming…
To illustrate the case, here’s several quotes and links from today’s media:
Crenews.com: Federal regulators on Tuesday are scheduled to unveil and vote on the final provisions they have set for the US’s implementation of international banking standards that could result in banks pulling back on their commercial real estate activities, including lending, mortgage servicing and CMBS investments. Industry groups are lobbying to lessen the potential impact of the rules.
See also USA Today: Most banks are already in compliance with the rule, according to the Fed, though it estimates about 100 banks will need to raise roughly USD 4.5 billion in capital by 2019.The new rules simplify the risk calculations for mortgages, a process that community lenders had argued was too complex and would limit their ability to provide home loans. Community and regional banks comprise more than 90% percent of US lenders, according to the Federal Deposit Insurance Corp (FDIC). The Fed unanimously approved the 792-page set of standards, which were mandated by the 2010 financial overhaul law. The FDIC and the Office of the Comptroller of the Currency are also expected to approve the new standards
Reuters: However, the Fed warned it was drafting four more rules that would go beyond what the Basel accord called for, including one on leverage and another on a capital surcharge. (See full version of this story here.)
Why is this important? Because part of the Fed’s new remit since Dodd-Frank makes it responsible for bubbles in banking — it is even more interesting because clearly, to me at least, this is a major part of why Bernanke and Dudley at the FOMC are willing to ignore the lower inflation. This low inflation has both monetarist and Keynesians up in arms, and as it is often the case, the REAL reason for major macro paradigm shifts comes from policy mistakes in this case pro-cyclical regulation.
Prepare yourself and please do read the above. If not we are doomed to focus on QE-petering while Fed gives the whole banking industry a major margin call.
The Bottom Line (as Jakobsen comments) is that banks run on “leveraged” / borrowed money – Now the Fed is going to reduce their ability to use leverage which technically equates to a margin call – put more money up or reduce position.