Can You Rely on the Fed to Protect Your Bank Deposits?

Last week, the Fed vice chair for supervision, Michael Barr, announced that the regulator had cut a proposed increase to capital requirements for the largest US banks by more than half. According to Barr, the Fed will increase capital requirements for the largest U.S. banks by 9%. As a reminder, the initial plan was to increase the requirements by 19%, which was later cut to 16%.

In truth, even a 19% raise would have been a mild increase given the current state of the credit cycle in the U.S. Credit quality metrics of most lending products in the system are deteriorating quite rapidly, while exposure of large banks to shadow banking intermediaries and extremely risky structured products grows at double-digit rates. Yet, for some reason, the Fed and other regulators have decided to significantly reduce planned increases in capital requirements.

Yet, amazingly, the mainstream media and research agencies have lauded the 9% increase as a huge win for the largest U.S. banks. And, if you're following our banking work, you know that we have already written how JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Citigroup (C), and other large banks launched an unprecedented campaign against these changes.

The Bank Policy Institute, a trade group representing JPM and other large banks, reportedly hired one of the country’s top trial lawyers and had planned to potentially sue the Fed if the Fed did introduce those higher changes in capital requirements. Suing the Fed for its regulatory initiatives sounds unbelievable. Yet, the banking lobby was apparently ready to do that.

According to Reuters, Goldman recruited dozens of small business owners from all over the country and escorted them to meet senators in Washington. Goldman Sachs told them to urge senators to ask the Fed to reconsider the proposed changes in capital requirements. The meetings were arranged, paid for, and scripted by Goldman Sachs. Each small business owner had an agenda timed down to the minute.

The banking lobby even used billboards and launched an ad campaign on TV, suggesting that every American has an opinion about the Basel III regulation when very few even knew about the issue. These billboards and ads were also warning of “dire consequences for everyday Americans” if the original rules were to be approved.

Given the new proposal announced by the Fed, these efforts of the banking lobby were successful. We have already shared our thoughts about this unprecedented lobby campaign. Here's a quote from one of our previous articles:

The obvious question here is why large banks launched such a fierce lobbying campaign? At the end of the day, CEOs of large banks are constantly saying that their banks are well capitalized, and a well-capitalized bank can easily meet those mild increases in capital requirements.

First, given how the balance sheets of large banks look now, those statements about “well-capitalized large banks” are too optimistic - to put it mildly. If you follow our banking work, you know that we have published a lot of articles on various issues that are currently sitting on larger banks’ balance sheets.

Second, there's a clear conflict of interests between the banks’ senior management and the banks’ counterparties who are interested in its financial stability. Yes, we are talking now mainly about you - retail depositors. Bonus payments from senior management are almost always tied to one indicator, which is a return on equity - ROE. The initial changes would have very likely lowered the ROEs of large banks due to higher capital bases and lower degrees of risk taking. Lower ROEs mean lower bonus payouts, and these payouts are usually much higher than the annual salaries of top management.

A return on equity is an important metric for a bank, but there are other metrics, some of which are even more important for a bank in a crisis environment. For example, a return on equity is only one of the 20 metrics that we are using to evaluate a bank. But, as we can see, the goals of senior management do not seem to be aligned with those of depositors.

Another point is that there's no personal liability for a bank failure. This is the reason senior management at large US banks is taking so much risk on their balance sheets. High-risk banking activities increase ROEs in a growing economy and bull markets, and, as a result, senior management gets their bonuses. If a bank fails, then a worst-case scenario for senior management is that they lose their jobs. As such, only regulators can prevent senior management from excessive risk taking.

It's quite amusing to consider that large banks worry that the new capital rules would affect their ability to grant residential mortgage loans and business loans. They have already mostly refocused their lending activities from home loans and business loans to much riskier credit segments. According to the Fed, residential real estate loans grew by 3.3% YoY in 2023, while commercial and industrial loans were flat YoY. At the same time, credit cards, the riskiest segment in retail lending, grew by about 15% YoY in 2023. Moreover, loans to shadow banking intermediaries, which are a complete black box even for regulators, grew by 11% YoY.