Earlier this week, we laid out our assessment of the final, controversial “tailoring” rules issued by the FRB, OCC, and FDIC.  Some say these rules give big banks so much relief that the U.S. financial system now teeters on the brink.  Others pump them up as the fountain of M&A and an all-round earnings elixir.  However, analytics are more complicated than politics.  As we see it, the new framework gives a good deal to some banks and takes more than a little from others.  On balance, it’s a net gain across the sector of large U.S. and foreign banks that are not branded as U.S. GSIBs.  However, the potential for renewed basic banking or redistributed earnings will still be limited – most bankers will be reluctant to head into higher-risk products at a time of accounting uncertainty and acute macroeconomic and political risk.  Sheltering in place with some additional capital distributions is thus likely to be the new rules’ near-term result.

Much in the rules follow recommendations we laid out in a 2017 report assessing the implications of substantive relief for large regional banks.  Based on this analysis, we differ with the agencies effort to placate critics with the de minimis benefits presented in the tailoring rule.  Regional and even super-regional banks will get balance-sheet relief and, as a result, meaningful capital capacity with which to reinvest in basic banking, finally up their tech game, engage in M&A, or simply placate shareholders with larger distributions.  Each bank will plot its course through these new incentives, endangering any effort at top-level conclusions be they pro or con.

We used a very different cost-benefit analytical (CBA) methodology than the banking agencies.  We think it far more productive to look at regulatory changes from a marginal CBA perspective, not to look at each aspect of a proposed change as if it’s the only variable with any impact. 

Agency CBAs look at one change – e.g., the elimination of the advanced approach – to assess a rule’s effect.  This is essentially a binary CBA model:  you look to see if taking one thing from a system that has only one thing makes a difference.  We look at one change in the broader context of other relevant factors – i.e., all the other capital rules that would still bind a bank in the absence of advanced-approach elimination and what liquidity-rule changes due to mandatory holdings of leverage-capital-intensive assets.  Marginal CBA thus considers this rule as a system with approximately thirty elements, thus illuminating what the new bank looks like, not what one change does to one rule.

The agencies’ CBA also go back to grade school in terms of mathematical conclusions.  The rule’s CBA totals numbers for a group consisting of any bank even mentioned in the final rule, even though impact varies enormously within the overall group.  For example, the new tailoring rules keep GSIBs largely as is.  But, since they account for approximately 66% of U.S. bank assets and a slightly larger percentage in the group of banks covered by the rule, the zero capital overall impact for the group as a whole averaged into the impact conclusion obscures the sizeable impact for regional banks.  Most of these will get significant capital and liquidity relief, with much of this due not to the simple capital number which the agencies cite, but instead to the interaction of the capital and liquidity rules in terms of overall balance-sheet relief – unmentioned in the final agency impact statement.

And then there are the externalities.  Add CECL to the mix and the new framework, for all its tailoring, still cuts deeply, especially into regional banks with credit-risk intensive business models.  As we’ve noted, new CECL-forced reserve requirements will better insulate banks from long-term risk, but do so at immediate cost to regulatory capitalization.  The prospect for still lower rates also mitigates potential reward since banks will be reluctant to make loans with the balance-sheet capacity freed up by reduced liquidity requirements.  Short-term asset arbitrage activity could be the name of the game, especially for as long as the Fed backstops the repo market to provide a sure and certain IOER spread.   

And, each bank getting capital relief is different than each other bank getting capital relief.  Some are large credit-card lenders and thus see the NIM equation differently than others with their eyes on longer-term corporate lending.  All will indeed gain flexibility, but at the end of the day I expect most to use it for long-delayed tech investments, targeted M&A, and a buffer against risks to come. 

In short, tailoring makes the new rules a better fit for regional and super-regional banks, a better fit that in an economic recovery with normalized interest rates could make a material difference in terms of equitable banking services to under-served consumers.  For now, though, the new rules provide only some breathing room, relief far from the cataclysmic reconfiguration of U.S. bank regulation critics still allege.