Originally published in The Financial Times.
Financial history is littered with the unintended consequences of regulatory changes. Capital controls in the 1960s drove international borrowers to move from the US to create the eurobond market. The deregulation of savings and loan banks in 1980 contributed to the industry crisis later that decade. And on and on.
Sometimes these are unforeseeable as complex systems adapt and interact in unexpected ways. But sometimes they are foreseeable, not least because financial reforms are often rushed after a crisis — as Yale Professor Roberta Romano argued in a 2021 Wallenberg lecture.
So, what to make of the Federal Reserve’s proposal for new bank regulation. Dubbed the “Basel endgame”, it calls for a 20-25 % increase in capital requirements for the largest banks, according to JPMorgan’s Jamie Dimon. The comment period on the proposal ended on January 16. Investors have been right to fret. Aside from worries that such a sharp increase in capital could slow economic growth by reducing lending, three possible unintended consequences stand out.
First, a new threat to the US energy transition lurks in bank regulation. The proposals contain a rule that could inadvertently throw cold water on billions of dollars of solar and wind investments.
Banks have been significant providers of finance to green infrastructure projects through so-called tax equity schemes. These allow them to offset their own tax liabilities by providing finance to the project. The banks account for more 80% of the roughly $20bn annual tax equity market — which may need to grow to more than $50bn to meet the goals of the Inflation Reduction Act (IRA), according to the American Council on Renewable Energy (Acore).
However, the proposed rule would increase by fourfold the capital required for a crucial source of funding for solar or wind farms, rendering them prohibitively expensive for many banks. Already, some banks are pausing, according to policy advisory group Capstone. And passage of the proposal could ultimately shrink annual tax equity investments by 80-90%, according to Acore. The private credit market could pick up some, or perhaps all, of the slack over time. But the unravelling of this source of finance could hinder the financing of many projects the IRA envisioned.
Second, the Fed may need to step in as the lender of last resort more frequently. The biggest in proposed bank capital requirements is for “market risk” — such as trading bonds. How much capital a bank has to keep as a buffer depends on the amount of assets it has adjusted for risk — the more risk, the higher the buffer. The rules propose that for capital for trading, the risk weighting increase by a whopping 70%. There is already considerable concern about the withdrawal of banks in market making — and this is likely to make this issue worse. The Fed had to intervene to support the Treasury market in 2019 and 2020 and it may need a permanent support facility if these proposals were to be introduced unamended.
Third, the proposal could incentivize more corporate lending to shift to private markets. It is likely to penalize those within the regulated sector, relative to those providers just outside, incentivizing financial flows towards the unregulated — what Professor Charles Goodhart calls the “boundary problem”. Finding the right balance and identifying risks is inherently difficult. But the initial Fed proposal suggests the boundary could shift significantly — a boon to private credit players, and perhaps international banks.
For example, one proposal suggests loans for small and midsized companies should have a risk weighting of 100%. But if the company is deemed investment grade with a bond listed on an exchange, a more favorable risk weighting of 65% is proposed. Today, very few small and midsized groups issue bonds. This would penalize their cost of funding and encourage them to seek finance outside of the banking system. That is why European regulators have not gone down this road. Moreover, the Bank Policy Institute suggested the actual loss experience warrants a risk weighting of 38%.
Meanwhile, many of the issues which led to Silicon Valley Bank’s failure — poor supervision, interest rate risk and depositor concentration — are left unaddressed in these proposals. Absent the Basel endgame, the investment case for US banks has greatly improved with the Fed pivot to a more dovish stance on interest rates. But investors should watch the unintended consequences of the rule changes closely to help gauge how far regulators may recalibrate and alter credit flows.
Read the original piece, here.
Read more about the Basel endgame and its implications for banks in our Annual Outlook For Wholesale Banks With Morgan Stanley, here.
