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The Federal Reserve proposed new rules on Tuesday to restrain risk-taking by the largest U.S. banks as it tries to make the financial system more resilient against future crises. By Reuters December 20, 2011.
The Federal Reserve came out with a Christmas eve proposal of new rules to curb risk-taking by the largest U.S. banks and ‘future proof’ the US banking system from the TBTF (too big to fail) and TBTB (too big to bail) banks making any adventurous moves leading to future crises. It is certainly not Santa Claus visiting with a bagful of goodies!
The Fed has thrown open the whopping 173 page document for comments until March 31, 2012.
This is a significant move by the Fed; in light of the ‘systemic risk’ posed by large banks and the stringent Basel III rules coming out. Against the backdrop of analysts commenting on EU banks needing more than 140 Billion Euros in additional capital, this seems to be a logical move; despite misgivings by some of the large US banks.
The rules emanating from the Dodd-Frank Act, are far reaching and will have a significant impact on capital, liquidity and risk management. Broadly, these rules touch upon:
- Risk Based capital requirements and leverage limits
- Liquidity requirements
- Risk management and Risk Committee requirements
- Single counter-party credit limits
- Stress Testing
- Debt Equity limits
- Early remedial framework
The Fed said both the capital and liquidity requirements would be implemented in two phases.
The first phase would rely on policies already issued by the Fed, such as the capital stress test plan it released in November. That stress test plan will require U.S. banks with more than $50 billion in assets to show they can meet a Tier 1 common risk-based capital ratio of 5 percent during a time of economic stress.
The second phase for both capital and liquidity would be based on the Fed's implementation of the Basel III international bank regulatory agreement. That standard brings the Tier 1 common risk-based capital ratio requirement to 7 percent, plus a surcharge of up to 2.5 percent for the most complex firms.
Stress tests of the companies would be conducted annually by the Fed Board using three economic and financial market scenarios. A summary of the results, including company-specific information, would be made public. Banks are also required to conduct one or more stress tests each year on their own and to make a summary of their results public.
The Board is proposing a number of triggers for remediation--such as capital levels, stress test results, and risk-management weaknesses--in some cases calibrated to be forward-looking. Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.
While the Fed has made its intentions very clear – curb excessive risk-taking and obviate creating distortions in the financial system; it is pertinent to ponder over the implications for the large banks covered under these new rules. Of course, we can expect to see an intense round of lobbying again; but banks do not have much room to wiggle out of this pincer.
- The additional capital surcharge means that shareholders will have to live with lower returns and top brass with lower bonuses. Again, with depressed economic conditions making revenue growth a tough challenge, focus will again be on cost cutting and optimizing operating costs.
- There will be added burden on administration and compliance to fall in line with the additional enhanced standards for covered companies relating to (i) contingent capital; (ii) public disclosures; (iii) short-term debt limits; and (iv) such other prudential standards as the Board determines appropriate.
- Public disclosures of stress tests and the added transparency will mean banks are going to remain the cynosure of the eyes of consumers and regulators.
- The proposal rules to implement the early remediation requirements means that Risk Management will have the task of establishing measures of financial condition and remediation requirements that increase in stringency as the financial condition declines.
- Banks must submit to the FDIC a plan for rapid and orderly resolution under the Bankruptcy Code in the event of its material financial distress or failure, as well as a periodic report regarding credit exposures between each covered company and other significant financial companies. This means that banks will have to be whistleblowers for their own deeds!
- By giving teeth to the Fed to act in case of threats posed by any bank towards systemic failure, the rules put a lot of onus on the regulators to ensure a repeat of the 2008 collapse never happens.
- By declaring these rules, the Fed has virtually announced its acceptance of the Basel III norms of materially improving the quality of regulatory capital and introducing a new minimum common equity requirement. Basel III also raises the numerical minimum capital requirements and introduces capital conservation and countercyclical buffers to induce banking organizations to hold capital in excess of regulatory minimums. All this is far removed from the practices followed by US banks till date.
- The enhanced requirements of Liquidity resilience and liquidity coverage changes the operating norms of banks. Keeping sufficient ‘cash’ means less room for creative lending.
- By laying down norms for Enterprise Risk management and putting a rule of at least one risk management expert amongst the independent directors, these rules raise the stature of risk management and put enormous burden on the risk committee.
- Stress testing is now a forward looking exercise; unlike the ‘forced’ kid gloves approach by regulators. The onus is also on the banks to conduct ‘self stress tests’ and share the results publicly.
Clearly, as bankers scratch their heads in their planning for 2012, the Fed has given them more food for thought!
It remains to be seen whether bankers will come up with creative ideas on cost savings and sound risk management that enable stable profitable growth; or continue as ever with hectic lobbying and taking cover under the ‘cannot afford to fail’ line.
The banks which display sound agility and heightened ability of functional excellence in these changed conditions will be the ultimate winners.
These rules have established beyond doubt that our world of banking has changed forever and will probably never return to the heady days of exotic products and hectic risk taking.
In late June 2011, the Federal Reserve Board published the long dreaded final rule on the debit card interchange fee rates. The initial draft from the Federal Reserve had proposed a fee cap at 12 cents, prompting widespread criticism from the banking industry. On June 30, the Fed issued the 331-page final rule for Regulation II – the ‘official’ name for the swipe fee rule – which proposes to cap the swipe fees at 21 cents plus 5 basis points of the transaction. The debit ‘swipe fee’ rule took life on Oct 1, 2011 and since then has generated more heat and dust than any other regulation in recent times. To make it more confusing, the Fed has divided the affected banks into two categories – 1) Exempt 2) Non-Exempt. Banks with less than $ 10 Billion in assets are exempted from the swipe fee rule. Banks with assets greater than $ 10 Billion are subject to the debit interchange cap. http://www.federalreserve.gov/paymentsystems/debitfees.htm
Debit is no longer the reliable source of strong revenue for card issuers. Banks have to rethink seriously and go through a critical evaluation of not only debit, but also focus on rebuilding the use of credit cards and promoting alternate payments like prepaid. In short, a radical rethink can only enable banks to reposition themselves effectively in this changed market environment.
What is the impact?
Although the final “Regulation II” limited the anticipated debit interchange revenue shortfall from 44 cents to 21 cents, the financial impact is still substantial. When banks consider this in conjunction with all other regulatory changes affecting credit card charges and checking overdraft coverage, analysts hold that banks are still looking at more than a $ 7 billion annual revenue loss. This loss is exclusive of other market factors such as operating costs, tight margins and the impact of the great recession. The banks can’t be optimistic and this figure could grow even higher with likely future regulatory impacts from the newly formed Consumer Financial Protection Bureau.
Is the Consumer really going to benefit?
The spate of new regulations was intended to benefit consumers and retailers. In the wake of new rules, the obvious question now is, “Will consumers and retailers realize any gains”? Thus far, it looks like only the retailers’ margins have improved. It doesn’t look like any gains retailers have passed on their gains to end consumers.
So far, it appears that only the banks’ loss of revenue is given. Whether banks’ loss is going to translate to consumer gain remains to be seen. Banks cannot afford to absorb another dent to their financials without a fight! But after the lobbying slugfest, retailers and consumer interest groups are on high alert on fees and charges and will continue to be extremely wary of banks and are unlikely to rest on their victories.
The expected conventional response:
Some of the banks have already made their intentions clear and have come up with the expected responses, charging elsewhere to account for losses somewhere. These responses are focused on the following:
- Charge fees on checking accounts: Banks who feel that debit interchange fees has ‘subsidized’ free checking accounts, are now moving towards charging annual fees and other charges. Unfortunately, Bank of America’s famous $ 5 fee fiasco has pre-empted other banks from doing so.
- Stop Debit Rewards: Some of the banks have stopped debit rewards thereby making it unattractive for cardholders to retain a preference for debit. Rewards on debit spends that were affordable at the earlier interchange rates are no longer sustainable.
- Impose spend limits: Some of the banks are actively considering restrictive limits on debit card spends. Daily limits on retail spends is an option to reduce transaction volume on debit cards.
- Increase fees on other products: Banks are scanning their retail services portfolio to evaluate the options for raising fees on services that are outside the regulatory scope.
However, the above options are more knee-jerk and fraught with the risk of heightened regulation and consumer backlash. The Regulators are likely to help the consumers best able to adapt to the changes. The possible outcome of retailers not passing the benefits of reduced interchange fees to cardholders by way of lowered prices; but banks making it more expensive for customers on checking accounts will lead to highly negative consequences.
The retail banking landscape has changed permanently and will never be the same again. To succeed in this tough new marketplace, banks also have to change themselves to match the demands of customers and also to conjure strategies to revive depleting revenues.