Regional Banks: Funding and Regulatory Challenges Following the U.S. Banking Crisis

The U.S. regional bank crisis has created funding challenges for banks who ultimately turned to the Federal Home Loan Bank system and other sources for liquidity. Additionally, there are new long-term debt and capital requirements for regional banks in the works.

Long-Term Debt ("LTD") Proposals

The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve have published the long-term debt proposal for the U.S. regional banks. The design and overall content, broadly speaking, did not present many surprises, especially when it's set against the requirements globally.

The FDIC and the Regulators have proposed permanently embedding existing legacy instruments. Assuming implementation today, this action will help to reduce the net shortfall to the requirements and should provide relief to compliance pressure in the short term. However, the benefit of legacy instruments will run out fairly quickly, and certainly by the time the requirements are fully phased in.

Proposals’ Impact on Regional Banks Will Vary

The long-term debt proposal is pretty much what the market has been expecting. While $30 billion to $50 billion of expected LTD issuance over three years sounds straightforward, it's important for investors to note that most regional banks will encounter different obstacles in achieving LTD requirements.

Some regional banks will easily fulfill the long-term debt requirements over the extended time period — even at the 100% level – while others with a smaller legacy debt portfolio footprint will face larger challenges as they will require approximately $5 billion to $7 billion of HoldCo issuance over the next few years. This, in turn, will create EPS drag, which will be a metric required to be monitored by both bond and equity investors.

Increased Debt Issuance Ahead of Long-Term Debt Implementation

One benefit of this expected result is that issuers have already been preparing for it given the rumors. Thus far in 2023, we've seen dramatic increases in debt issuance from the U.S. regionals in the context of ~30% YoY growth relative to 2022 and ~100% YoY growth relative to 2021. Notably, this increase in debt issuance has occurred despite a broader decline of issuance in the broader financial services sector of ~30% YTD relative to 2022.

Regionals vs. G-SIBs

If we look at the impact of Basel 3 Endgame for the U.S. G-SIBs, it is expected to lead to ~20% to 25% of Risk Weighted Asset (RWA) inflation. There's a wide degree of business model variation, similar to the long-term debt rule, which ultimately leads to a variance in the manifestation of the RWA inflation. At the lower end of that range will be the money centers and trust banks (~20%), followed by the brokers at the higher end of the scale (~25%). The proposal indicates Operational RWA will be derived from fee income and operational losses. The slightly riskier business models of the brokers drive their higher RWA inflation; while the opposite is true for U.S. Regionals (expected to see ~5% to 10% RWA inflation), which seems quite manageable.

Similar to long term debt, the devil is in the details. The G-SIBs have already been operating with the very high Common Equity Tier 1 (CET1) levels – therefore, they can absorb and grow into these higher RWA numbers. In the next couple of years, they're going to be able to earn back the CET1 lost as a result of the denominator change.

For the regionals (Category III and Category IV banks), we haven't mentioned the elimination of the AOCI (Accumulated Other Comprehensive Income) exemption. There's difficulty upon difficulty (LTD, AOCI and now B3 Endgame) for regional banks, in addition to starting from a much lower CET1 base. As a result, the expected 5% to 10% of RWA inflation is more impactful in terms of their CET1 requirement.

The elimination of AOCI was 100% expected. We've already seen the regionals that are really in the crosshairs for this being proactive – there's not much scope for RWA optimization considering the proposal is at least operational. RWA is based on fee income, which is not as easy to tweak, so they will have to be more responsive with things like the suspension of share buybacks. In fact, suspension of share buybacks was a theme for U.S. regionals during second quarter earnings. We expect that behavior to continue – particularly for those with business models that are likely going to take three to four years to earn back that EPS hit, as opposed to one to two years (G-SIBs).

M&A Implications

Banks hovering around $90 billion in total assets have to be quite careful around their RWA, as it could act as a catalyst for M&A. When we mention EPS accretion and the difficulties that the regionals are going to face there, we often add in all the legacy discussions around economies of scale with respect to topics such as regulatory compliance and cyber security. Eventually, the discussion around potential M&A will come to the forefront.

Bank Funding – Home Loan Bank System Debate

Home Loan Bank advances have become an issue for policy in Washington. There's speculation that the Federal Home Loan Bank System (FHLB) is under some pressure to consider whether Category I banks should still benefit from access to the Home Loan bank system and access to advances. Advances are a way banks raise secured financing for mortgages; this can also be done directly through the covered bond market, which is a significant and vibrant market and certainly could absorb supply from the U.S. majors.

It feels as though there are taxpayer subsidies occurring. As an example, a typical price for a five-year advance might be SOFR plus 50, while a typical price for a five-year covered bond would be SOFR plus 100 for similar secured mortgage portfolios. It doesn't make sense that the biggest banks in the U.S. should enjoy that sort of taxpayer subsidy for what they would be able to raise via public capital markets.

However, the smaller community banks, with assets of $50-$100 million, are the real beneficiaries of the FHLB system. When the G-SIBs and regional banks use the FHLB, they are the ones that ultimately provide the funding that ends up benefitting the community banks. If those fixed costs had to be paid solely by the community banks, the cost of those advances would be much higher. In terms of covered bonds, they take more assets away from the receivership (should a bank fail) and potentially may increase the costs of resolution. This will continue to be an interesting point of debate.

FDIC Premiums

It's not just the U.S. trying to make the resolvability of banks a more cohesive process that promotes financial stability. In Europe, they recently proposed general depositor preference whereby all deposits, insured and uninsured, all rank pari passu in failure as a way to enhance depositor protection. Following this year's banking crisis, we are seeing globally more focus on crisis management reforms and looking at Deposit Insurance reform.