Regulators' capital crackdown is coming at an inopportune time

Bloomberg News

There's a scene from The Memphis Belle — one of the most saccharine war movies of modern times — when World War II allied bomber flyboys are watching a fellow squadron come back from a mission, anxiously counting the planes approaching the runway and hoping everyone makes it home safe. Finally, Eric Stoltz sees the last plane coming over the horizon, and everyone cheers for a job well done. But trouble is afoot: The landing gear isn't down, and the bomber crash-lands on the runway. Even then, the plane is still intact — until it suddenly explodes, along with the aviators' high hopes for a soft landing.

When I hear the words "soft landing" in the economic context these days, this is the image that immediately comes to mind. On the one hand, the Federal Reserve's quest to quell inflation seems to be going reasonably well — headline and core inflation metrics are down year over year, and though the "last mile" problem could prove vexing, consumers' own expectations for inflation have moderated considerably, and that is in many ways the hardest battle to win.

That's the good news. The bad news is that conditions for banks — particularly larger banks — in the short- to medium-term are becoming increasingly perilous. We've by now become quite aware that banks in general have an interest rate risk problem — holding a large quantity of securities that bear interest rates below their current cost of funds, putting the squeeze on their bread-and-butter interest rate spread income. 

Many of these same banks are also heavily invested in commercial real estate ventures — a sector that regulators increasingly view with concern because so few people are going back to the office post-pandemic. Making new, profitable loans to buoy up the unprofitable ones is also increasingly hard because credit conditions are tighter and loan demand is down — a trend largely attributable to persistently high interest rates. 

And on top of that you have credit ratings agencies circling the banking industry for collective and individual credit downgrades — moves that will make it still more expensive for banks to raise capital through the bond market should the need arise. 

These headwinds are considerable, but not insurmountable — this isn't like a 2008 or 2020 scenario. But it is a backdrop of heightened tension, where banks have less room for maneuverability or mistakes, and things just aren't allowed to go wrong. 

Regulation and compliance

Gruenberg: Long-term debt, uninsured deposit reform coming for big banks

August 14, 2023 4:45 PM

And it is against this backdrop that Federal Deposit Insurance Corp. Chair Martin Gruenberg expounded on where he and his fellow regulators go from here to shore up the safety and soundness of the banking industry after a historic slew of bank failures and a systemic risk exception that cost the Deposit Insurance Fund billions of dollars earlier this year. 

Those features include applying long-term unsecured debt — known as Total Loss Absorbing Capacity — to banks with more than $100 billion of assets, a bail-in capital provision outlined by the Basel III accords that the largest banks are already required to hold. Gruenberg also discussed a fundamental reconsideration of the living wills requirements, including the ability for banks in distress to rapidly create a virtual due diligence data room with "enough information for interested parties to bid on the bank or certain of its assets or operations." And the FDIC is also considering ways to make banks with a greater presence of uninsured deposits pay more for their deposit insurance.

Individually, all of this makes sense. Signature Bank didn't have a living will before it failed, so it would stand to reason that resolution of the bank would be easier if banks were required to have one, and if banks could bid on Silicon Valley Bank's assets individually that might have led to a speedier resolution. TLAC may have stabilized funding for Silicon Valley Bank and prevented the kinds of runs that ultimately led to its demise. I don't think anyone would object to banks with high rates of uninsured deposits paying some kind of premium for having riskier funding sources. 

The challenge instead is that all of this is coming at once, and it is coming at a time when the administration at the highest levels is trying to paint a rosy and optimistic economic picture ahead of next year's election. 

It's worth noting that while all of these things are being discussed today, whether and when these developments ultimately come home to roost will play a very big part in how soft a landing the banking system — and by extension the economy — ultimately experiences. The Basel III: Endgame proposal is still just a proposal, and even if it is left unchanged — a prospect I rather doubt — it won't be fully implemented until 2025. The bond ratings agencies may or may not downgrade banks, and if they do it may or may not matter. The Fed may pause, raise or lower interest rates over the course of the next couple of years, though I doubt rates will fall precipitously. And all those other rules Gruenberg discussed aren't even proposed yet, much less finalized, much less implemented. 

So nothing is set in stone — banks can still weather this phase, however tenuous. But the margin for error seems to be increasingly slim — and that could mean the difference between a soft landing and a crash landing.