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  • Writer's pictureMichael Amelio

Regulatory Pressure Compels Regional Banks to Increase Debt Levels, Leading to Further Strain

In a recent development, U.S. regulators have unveiled a set of intentions aimed at requiring regional banks to issue debt and reinforce their "living wills," a strategic move designed to safeguard the public in the event of potential future failures within the banking sector.

Under the proposed measures, American banks possessing assets of at least $100 billion would be subjected to the new stipulations. These regulations would mandate these banks to maintain an additional layer of long-term debt, intended to absorb potential losses in case of government intervention. The collective effort comes from the Treasury Department, the Office of the Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corp.

These regulatory steps are in response to the regional banking crisis that emerged in March, leading to the collapse of three institutions and negatively impacting the earnings potential of several others. The initial wave of anticipated changes was introduced in July, comprising an extensive array of proposals focused on raising capital requirements and standardizing risk models within the industry.

According to a fact sheet released by the FDIC, the impacted banks will need to uphold long-term debt levels that correspond to either 3.5% of average total assets or 6% of risk-weighted assets, whichever is higher. Moreover, the regulators are discouraging banks from holding the debt of other institutions to mitigate the risk of contagion.

The proposed requirements are expected to result in "moderately higher funding costs" for regional banks, as acknowledged by the regulatory bodies. This could further exacerbate the earnings pressure already faced by the industry, given that multiple credit rating agencies have already downgraded credit ratings for certain banks this year.

However, banks will have a three-year grace period to conform to the new regulations once they are enacted. Regulators suggest that many banks already hold forms of debt that meet the proposed requirements, estimating that approximately 75% of the necessary debt is already in place.

The KBW Regional Banking Index, which has seen significant losses this year, experienced a minor increase of less than 1% in response to this news.

It was widely anticipated that these changes would be implemented, especially after the sudden failure of Silicon Valley Bank in March raised awareness among customers, regulators, and industry executives regarding emerging risks within the banking system. The proposed measures extend from the largest institutions, often referred to as global systemically important banks (GSIBs), down to banks with assets totaling at least $100 billion.

The regulatory actions encompass various aspects, including increasing the levels of long-term debt, eliminating the loophole that previously allowed midsize banks to sidestep the recognition of losses in bond holdings, and mandating the creation of more robust living wills or resolution plans that would come into effect in the event of a failure.

The regulators are also considering revising their guidelines related to risk monitoring, including high levels of uninsured deposits. Changes to deposit insurance pricing are also being contemplated to discourage risky behavior. This comes in response to the fact that the three banks seized by authorities this year had substantial amounts of uninsured deposits, a key contributing factor to their failures.

Analysts have focused their attention on the impact of the debt requirements, as this is the most significant change for bank shareholders. The purpose of raising debt levels is to ensure that in the event regulators need to take control of a midsize bank, there's a layer of capital available to absorb losses before uninsured depositors are affected.

Morgan Stanley analysts led by Manan Gosalia noted that these requirements will compel some lenders to either issue more corporate bonds or replace existing funding sources with more expensive long-term debt. This move is expected to further compress margins for midsize banks, which are already grappling with rising funding costs. According to Gosalia, this group could witness an annual reduction in earnings of up to 3.5%.

Among the banks identified by analysts to potentially require raising approximately $12 billion in fresh debt are Regions, M&T Bank, Citizens Financial, Northern Trust, and Fifth Third Bancorp. These banks have not yet provided official responses to these projections.

FDIC Chairman Martin Gruenberg has emphasized that maintaining adequate long-term debt serves to reassure depositors during times of financial distress, reducing costs to the FDIC's Deposit Insurance Fund. This also increases the likelihood that in the event of a bank's potential acquisition over a weekend, the process can be conducted without the need for extraordinary measures reserved for systemic risks. Additionally, it provides regulators with more flexibility in such scenarios, including the possibility of replacing ownership or dividing banks to facilitate their sale in segments.

Gruenberg highlighted that the new proposal requires impacted banks to issue new debt. This long-term debt won't create liquidity pressures when challenges become evident. Unlike uninsured depositors, investors in this debt understand that they won't have the ability to withdraw their funds when difficulties arise.

The requirement for long-term debt in midsize banks is expected to incentivize investors to diligently monitor risk, and these publicly traded financial instruments will convey the market's perception of risk associated with these banks.

Regulators are open to receiving comments on these proposals until the end of November. It's important to note that trade groups had previously expressed strong objections when regulators initially unveiled parts of their plans in July.

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