Last week Fitch Ratings announced research showing that, under regulatory amendments now in progress, the 29 global systemically important banks may need to raise $566 billion in new capital before all of the rules and regulations take effect in six years. Since some of the actual rules aren’t written yet, Fitch has made some assumptions about the final amount of capital. Even if the rating agency’s assumptions are not completely accurate, it is clear that the amount of capital required by banks to meet regulatory expectations will be nothing short of staggering.
Where’s the Money Going to Come From?
While regulators around the world are insisting that these systemically important banks increase capital, none of these regulators have provided guidance as to how banks might find such enormous sums. This demand comes as banks are facing a number of serious hurdles in attracting new capital:
- Many of the banks that accepted governmental aid in the last few years have been forced by their regulators to reduce or eliminate their dividends altogether.
- The Volcker Rule will eliminate bank proprietary trading and the profitable (if arguably risky) revenue streams it produces.
- Additional compliance requirements resulting from post-crisis legislation like Dodd-Frank will increase the regulatory burden and potentially limit bank’s ability to source new streams of revenue.
Poor dividends, reduced sources of income, and increased regulation all suggest that banks face a tough six years as they try to procure over half a trillion dollars of new investment.
Under new regulatory rules, known as Basel III, the firms will need roughly 9.5% Tier 1 common equity compared to the risk-weighted assets of the bank. To meet this tough standard, Fitch says, the banks are likely to hoard future earnings, cut dividends and reduce exposure to risky investments like underperforming real estate portfolios. They point out that the key to achieving the target will be winning new investment.
To Win New Investment, Control Risk
Better management of the balance sheet will be the first step in encouraging new investment. In order for these large banks to produce the approximately $20 billion in new capital that each is expected to produce, they will have to demonstrate to the investment community that they eliminated some of the risky behaviors that lead to the financial crisis in the first place. In addition to better credit controls these banks will need to establish that they are making improvements in operational risk.
Improved operational risk will be critical for two important reasons:
- First is the ability to reduce large errors like rogue traders or litigation from mortgage enforcement complications.
- Second, demonstrating reduction in operational risk will enable a regulator to reduce the amount of capital that a bank is required to hold against its risk-weighted assets. The process is not simple and it will not offset the half trillion dollars in capital that is being sought, but it can lighten the load of capital-raising.
Before going hat in hand to new investors, banks would be wise to make sure that they have a good story to tell, including a good grip on the institution’s operational risk.