Regulators may be ushering in a two-tiered banking system

WASHINGTON — It should be no surprise to any diligent reader of these pages to learn that things are getting tough for banks — particularly banks with at least $100 billion of assets — and will get tougher in the coming months and years. 

For the biggest and/or most systemically significant U.S. banks — known as global systemically important banks, or GSIBs — a recent proposal to implement the Basel III: Endgame framework would result in a 20% increase of overall capital retention (though that proposal's finalization as proposed is far from a sure thing). More recently, today the Federal Deposit Insurance Corp. proposed a slate of rules that would expand requirements on banks. First, banks with more than $100 billion of assets will now have to hold long-term debt sufficient to recapitalize a failed institution. Second, the new rules intensify the requirements for banks above $100 billion to submit resolution plans. And in the near future, regulators are poised to finalize rules regarding Community Reinvestment Act implementation, late fees and bank data access. 

A lot can happen between the proposal and finalization of a rule, and banks retain the right to challenge final rules in court — so, again, none of this is a done deal. But let's consider what the banking system would look like if these proposals all come through more or less the way they're proposed and more or less according to their expected timelines. 

One predictable effect would be that large banks — particularly the midsized regionals that have come under heightened scrutiny after three of them failed earlier this year — will become less profitable. 

Part of that is because it's not the greatest time to be a bank — net interest income is down because of the prevalence of underwater securities and the higher cost of funds sparked by a dramatic increase in interest rates over the past 18 months or so, and weakened loan demand is simultaneously making it harder for banks to shore up their balance sheets with more profitable loans.

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The other part of that lost profitability would be because these rules come with costs — retaining more capital costs money, submitting living wills costs money, acquiring long-term debt may be difficult depending on timing and market appetite, and lower revenue from late fees and/or data sales could compound the pinch.

None of that is to say that regulators are wrong to move forward with any of these rules — the shortcomings of the existing resolution regime and their impact on the financial system is reasonably evident given the way that the failures of Silicon Valley Bank, Signature Bank and to a lesser extent First Republic went down. But these headwinds will also spur many banks to look for ways to maximize their economies of scale and remain competitive, and in many cases that points to one thing: M&A. 

Former Federal Reserve Gov. and widely-credited architect of the post-2008 regulatory apparatus Dan Tarullo said as much during a panel earlier this month at the Brookings Institution, arguing that the administration's reluctance to make it easier for biggish banks to merge or be acquired is at odds with an increasingly difficult business climate that regulators themselves are partially responsible for creating.   

"These banks are caught between, on the one hand, the GSIBs with their scale advantages and, on the other, the smaller regionals and community banks, which are better positioned to take advantage of such relationship banking opportunities as remain," Tarullo said. "So these midsize regional banks whose returns on equity have already declined by several percentage points are facing an even tighter competitive situation. That leads to the question of how a proposed merger involving one or more of those banks should be assessed."

Let us again assume for the sake of argument that the administration decides that increased M&A among midsized regionals actually makes sense. The natural evolution of the industry in that case would be for there to be a decently large and competitive industry made up of GSIBs and maybe a dozen super-regionals that are that much more stable and resolvable than they were before. 

But there will also be several thousand much smaller banks that are not subject to any of these requirements — thus sparing them the burden of complying with those regulatory costs in the short term, but setting the stage for a banking landscape in which they will be inherently less competitive. As Tarullo pointed out, those smaller banks will be able to take advantage of their in-person retail relationships in their own communities and also benefit from being big fish in the many, many small local economic ponds that we have all over the country. 

But as banking becomes more online — and bank customers become more accustomed to doing banking business online — that local economic moat and relationship banking model may not be enough to keep community banks in business over the long term. Banking, then, could become a kind of two-tiered system, with one set of rules for the kids table and another for the grownups. And if the rationale for that two-tiered system is that smaller banks can fail without regulatory intervention or systemic risk, then I suspect that, over time, failing is the recourse that many of the country's smallest banks will turn to as their competitive advantage dries up.