On Tuesday, September 19, 2023, Amelia Martella, Executive Director of the Fordham Corporate Law Center, hosted a webinar panel where presenters Anna Pinedo and Matthew Bisanz, both partners at Mayer Brown LLP, as well as Professor Richard Squire, Alpin J. Cameron Chair in Law, discussed the new Basel III Endgame capital requirements and long-term debt proposals that were released earlier this year by the Federal Reserve and Federal Deposit Insurance Corporation (FDIC).[1] The presenters considered what prompted these stricter banking regulations, what they entail, and how they will likely impact the banking sector and world economy. This discussion comes hot on the heels of November 30th, the due date for all public comments on the proposals.
Squire began the conversation by providing a backdrop against which these new regulations have arisen. He explained that this year’s failures of Silvergate Bank, Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank were the “four dominoes that fell” and led to demands for new regulations to stabilize banks. Given the high degree of maturity mismatch in banking, banks are particularly vulnerable to insolvency when their demand deposit accounts vastly outweigh their cash holdings. A run on the bank can be fatal in these cases.
With the stage set, Bisanz then discussed how the two proposed rulemakings will require banks to hold more capital and issue more long-term debt. The rationale, as Bisanz explained, is that “[I]f there is more equity and more subordinated debts below the deposits, then a bank can incur more losses on its asset side without becoming insolvent and causing the depositors to lose money.”
Bisanz discussed how the increased capital requirements are intended to lessen credit, market, and operational risks of bank activities, but noted that the ideas promulgated in these proposals actually predate this year’s bank failures, do not address the issues that caused them, and will impose huge financial burdens on the banks and the economy.
Expressing his doubt in the effectiveness of the broadened capital requirements, Bisanz argued “Any bank can fail given enough withdrawals and enough time.” He continued, “Even if you had triple the amount of capital contemplated under the proposals, a bank could still go insolvent if enough people withdrew the money or the assets incurred enough decline.”
Martella then invited Pinedo to discuss the impacts of the proposals on the economy overall, to which Pinedo suggested, “[T]he proposals would have a really significant and very adverse impact on a lot of regional banks, a lot of smaller banks, and a lot of smaller and medium size businesses.” She further compared the potential effects of these proposals to those that resulted from the Dodd-Frank Act.
The Dodd-Frank Act, which was enacted immediately following the financial crisis in 2010, was intended to prevent future financial crises.[2] However, as Pinedo illuminated, the legislation made it more difficult and expensive for certain categories of banks and businesses to function and led certain mortgage activities, that were traditionally done within banks, to be done by unregulated non-bank entities that were unregulated. Even worse, some services became unavailable to certain businesses, communities, and regions around the country. With the arrival of these new proposals, Pinedo worries that they may have the same effect and move activities from regulated institutions, the banks, to non-banks.
Additionally, Pinedo expressed her concern over the newly proposed technical revisions to the risk-based capital surcharges for global systemically important bank holding companies (GSIBs). She argued that these proposed revisions will make doing business in the United States less attractive for large foreign banks, who are important to the United States economy. These businesses, Pinedo predicts, will move to foreign banks, possibly in parts of Europe where the Basel standards have been adopted differently.
However, Pinedo does see the potential for good coming out of these proposals. She told the panel, “Within any disruptive change there’s the possibility for transformation and for organizations to come together and reorganize themselves in new and different ways.” Pinedo believes the proposed regulations can create opportunity for nonbanks, for banks who exist below the $100 billion threshold, for M&A activity, and possibly much more.
Bisanz then delved into the impact the newly proposed long-term debt requirements would have on banking operations and argued that this proposal, like the capital requirement, was ill advised. The regulators, Bisanz explains, believe that higher volumes of long-term debt issuance can provide optionality as well as a buffer to losses the government or depositors may suffer when bank runs occur. However, by accumulating more of this type of debt, other investments will necessarily be crowded out. Rather than investing in innovative businesses, banks may invest in long-term debt from regional banks because it will pay high interest rates due to all of its favorable features.
“Now we have the real economy investing in long-term debt instead of investing in electric cars or wind power,” Bisanz predicts. “And that can be a crowding out effect on some of the types of socially desirable investments that we might want to see come forward.”
When considering whether the long-term debt requirement is worth the costs to banks and other businesses, Bisanz stated, “If you told me this would prevent these banks from ever failing, maybe that’s a good argument.” However, Bisanz asserted that regulators know these proposals won’t prevent these kinds of bank failures and, instead, are merely looking to buy themselves more time and optionality when confronted by them.
Following up on Bisanz critique of the proposals, Squire closed out the webinar by speculating whether regulators were “tinkering with the wrong part of the balance sheet or just understanding the problem wrong.” He continued, “the real mismatch is between the deposits that could leave at any time and the amount of cash on hand. And that’s not being addressed directly [by the proposals].”
Squire asserted that regulators assume depositors are sophisticated and may be less likely to run if they perceive the bank can’t become insolvent because the debt-to-equity ratio is more favorable. However, Squire believes that the proposed changes are unlikely to reassure depositors.
“It’s a herd mentality,” Squire suggests. When depositors start running, others get nervous and follow suit. Squire argued that a debt-to-equity ratio is not going to prevent that. Instead, he again recommended that regulators focus on what really makes banks rickety, maturity mismatch. Large amounts of demand deposits can leave a bank quickly at any time and when the bank only has a small amount of cash available, they can’t cover the withdrawals and can ultimately fail.
While the public comment period is still open, if these proposed rulemakings take effect in their current form, there is little doubt that banks and businesses will undergo substantial transformations, as Pinedo predicted. However, whether this period of transformation will actually lead to stability in the banking sector remains to be seen.
[1] Regulatory Capital Rule: Amendments Applicable to Large Banking Organizations and to Banking Organizations with Significant Trading Activity, 88 Fed. Reg. 64028 (proposed Sept. 18, 2023); Regulatory Capital Rule: Risk-Based Capital Surcharges for Global Systemically Important Bank Holding Companies; Systemic Risk Report, 88 Fed. Reg. 60385 (proposed Sept. 1, 2023); Long-term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions, 88 Fed. Reg. 64524 (proposed Sept. 19, 2023).
[2] Dodd-Frank Act, Commodity Futures Trading Comm’n, https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.
