Evolving Banking Regulations in the US June 2013
New regulations may negatively impact the US banks’ profitability Banks form the backbone of any economy. Any regulation that is imposed on banks ultimately affects the end consumer. In recent times, on the back of the 2008 financial crisis, bank regulators have come up with numerous norms, which will definitely have an impact on consumers, hopefully in a positive way. However, banks seem not to be so happy with increasing regulations. There are three main regulations that will shape the US banking industry dynamics – Basel III, Dodd-Frank and Volcker Act. Though the Volcker Act is a part of Dodd-Frank, it is dealt separately as it affects mainly non-banking arms of banks. Basel III and Its Impact Under Basel III, strict capital and liquidity norms are being imposed on banks globally. These norms are being brought into effect because of deficiencies in financial regulation revealed by the financial crisis in late 2000. They seek to strengthen bank capital requirements by increasing bank liquidity and bank leverage. Though it is being brought to toughen the banking operation, it has affected banks adversely. The major impact of this regulation may lead to lower profits for banks. Under the Basel III arrangement, new capital needed would be around USD 60 Bn. The actual amount depends on the banks’ internally-generated capital from profits and their rates and types of asset growth. The Federal Reserve’s steps to maintain low interest rates for an extended period challenges interest margins, and thereby the banking industry’s ability to generate capital through earnings. Salient Points of the Basel III Norms •
Banks are required to increase the portion of their core capital to 4.5%
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They have to hold a minimum total capital of 8% of risk-weighted assets, i.e. capital held to back the loans they make – A common equity Tier 1 risk-based capital ratio is added
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Banks have to maintain the capital conservation buffer of 2.5%, which reduces the permissible amounts of dividends, stock buybacks and discretionary management bonuses
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Risk weights have to be changed for various asset classes – Higher risk to be assigned to non-traditional residential loans outside specified criteria such as interest-only mortgages or mortgages with balloon payments or certain ‘high volatility’ commercial real estate loans
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Banks will be required to increase capital for off-balance sheet items such as warranties for real estate loans sold by banks to investors, and loan commitments of not more than a year
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Banks will require additional capital to be adjusted based on the current market value of
EVOLVING BANKING REGULATIONS IN US
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held-for-sale securities Dodd-Frank Act Although the Federal Reserve does not apply the Basel III capital rules to bank holding companies with less than USD 500 Mn in assets, the Collins Amendment – Section 171 of the Dodd-Frank Act – requires holding companies to maintain the same types and levels of capital as FDIC-insured depository institutions. Therefore, the proposed new rules affect all depository institutions. However, many US Congressmen, the industry and even senior officials at the Federal Deposit Insurance Corporation (FDIC) and the Comptroller of the Currency have expressed concerns about inclusion of smaller banks. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has an addition called the Durbin Amendment. As per this amendment, swipe fees – the fee charged to merchants every time a customer pays with plastic – on debit cards issued by big banks have been lowered drastically, thereby reducing banks’ revenue, while lowering costs for merchants and therefore consumers. The amendment has two major goals: to introduce competition into the debit processing network, and to cap swipe fees just in case competition did not lower prices. Price control on debit card transaction has resulted in increase in profits at big-box retailers, higher costs to merchants, significant reductions in the revenue available to banks to serve local communities, with no changes in retail prices to consumers. After this amendment began to take effect on October 1, 2011, banks have priced lower swipe fees into their checking offerings resulting in less free or rewards checking. Since prepaid cards are not covered under this amendment, the market has seen an explosion of this product. Retailers have not lowered their prices because Visa and MasterCard jacked up their rates on small merchants. Volcker Rule Volcker rule prohibits banks from proprietary trading and has restricted investment in hedge funds and private equity by commercial banks and their affiliates. It also directs the Federal Reserve to impose enhanced prudential requirements on systemically-identified non-bank institutions engaged in such activities. Certain activities such as market making, hedging, securitization, and risk management are exempted from this rule. The rule also caps bank ownership in hedge funds and private equity funds at 3%. The affected companies will need to assess and redefine their strategies, especially for market making, hedging and covered funds. Bottom line: All these regulations prepare banks to better manage their risks and consumers’ welfare. However, efficacy of these regulations will be tested in the future when they come in full spectrum. Banks will be required to change their business model to match the pace of changing market dynamics to generate profits for their shareholders. Challenges are uncountable, so are the opportunities. Changing dynamics give huge opportunity to banks to tap unbanked population; shed loss-making, complicated business units; and simplify their legal structure.
EVOLVING BANKING REGULATIONS IN US
3|Confidential