Learning from the past experience of losing ground due to the weak capital level of banks, U.S. regulators are now focused on framing policies and standards at length. The precautionary measures include setting stricter capital requirements than what is required in a steady and growing economy. Moreover, the upcoming international banking regulations require banks to build their financial muscles. But the question is, how effective will this be to cure the economic infirmity?
Though many would be in favor of restricting banks through tough capital standards so that they can successfully combat another financial crisis, there are several hitches. Before analyzing the possible consequences, let's have quick look on the requirements from the banks.
Starting from sales to profit, banks are delimited with a number of restrictions following the latest recession.
In 2010, the regulatory officials of more than two dozen countries proposed a set of minimum capital standards for banks, known as Basel III. The intension was to prevent recurrence of a global financial crisis and restore public confidence. The committee mandated banks to hold more than triple the core capital to make them solvent.
Also, since 2010, the Fed has constantly been seeking higher capital levels from banks. In order to prove their financial strength, these banks have been going through the Federal Reserve's stress-tests since then. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn turned out to be deeper than expected. Since then, the test rounds are more like precautionary measures amid economic recovery.
The environment of the last two rounds of stress tests and the upcoming one are dissimilar to the Fed's first round.
The upcoming round is going to be even tougher. This time, the top 31 U.S. banks, with assets of $50 billion or more, will have to undergo stress tests. Out of the total, six big U.S. banks - Citigroup Inc. ( C ), Bank of America Corp. ( BAC ), JPMorgan Chase & Co. ( JPM ), Morgan Stanley ( MS ), Goldman Sachs ( GS ) and Wells Fargo & Company ( WFC ) - will have an even higher hurdle as they have significant exposure to the stressed European countries of Greece, Ireland, Italy, Portugal, and Spain - known as the PIIGS.
These banks would have to go through a hypothetical market shock to prove their ability to endure domestic as well as global recession. The hypothetical stress scenario would assume an increase in unemployment to above 13% in early 2013, a decrease in U.S. GDP by as much as 8% plus a significant slowdown in U.S. and global economic activities. Also, these banks have to prove their ability to keep their core Tier I common equity above 5% even under imaginary stress.
The hypothetical environment is even tougher than what these banks faced at the height of financial crisis in 2008. But the fact is that these banks were not able to confront the headwinds and had to implore government bailout. So, how will they face a tougher environment?
Actually, it may not be an impossible task for these banks as many of them have already strengthened their capital level to a great extent in recent years. But raising fresh capital and offloading assets were the only two ways to do it.
As raising capital is costly and difficult, shedding non-core assets was the most common way to strengthen capital level. Many of the big banks are still continuing with their asset-shedding activities.
But as banks are going asset light due to regulatory pressure, they are also restricting loan growth - a possible means of recovery.
The economic benefits of strict capital standards are indisputable. It goes without saying that these would keep the banks on their toes. Banking big-wigs would perform under pressure and try to build their weak capital levels, which threaten the economy. The whole exercise could ultimately translate into less involvement of taxpayers' money for bailing out troubled financial institutions.
But the most dependable banking names in terms of dividend payment will have to face tougher tests ahead. Naturally, their chances of passing the tests and gaining eligibility to enhance shareholder value are rather dim.
In fact, the challenge is not just contained to the big banks. The story is much the same for the other financial institutions that would find it difficult to raise dividends or buy back more stock.
Moreover, though the government is trying to protect the nation from another recession by forcing U.S. banks to be strong and healthy in terms of capital, this could force them to withdraw their investments from European countries. If this happens, the crisis in Europe will deepen further and backfire on our economy, shaping into an economic disaster that no one wants.