By Thomas Dee, Managing Director of Capstone’s Financial and Business Services practice

April 3, 2023 – US banking regulators testified before Congress last week, offering the clearest picture yet of how bank regulations will evolve in response to the failures of Silicon Valley Bank (SIVB) and Signature Bank (SBNY) three weeks ago. Capstone also hosted a day of meetings last week focused on the near- and long-term policy response to the recent events. Overall, we believe the regulators’ path forward is emerging – and it will pose meaningful long-term headwinds for regional banks and their equities.

Regulators’ path forward will pose meaningful long-term headwinds for regional banks and their equities.

Most impactful is the question of how regulators approach the substantial unrealized losses in banks’ securities portfolios, a key contributor to SVB’s failure. We expect the Fed to write new rules that require regional banks (likely those with >$100B in assets) to incorporate unrealized losses on available-for-sale (AFS) portfolios into regulatory capital – consistent with how the largest US banks are treated today. But regulators will be concerned that banks will simply reclassify securities as held-to-maturity (HTM), so regulators will likely enhance their scrutiny over those assets as well, perhaps through stress testing. Together, this will have a material impact on regulatory capital at regional banks, especially KeyCorp (KEY), Truist Financial Corp (TFC), Huntington Bancshares, Inc. (HBAN), and Fifth Third Bancorp (FITB).

We also expect regulators to extend the so-called enhanced prudential standards (EPS) to regional banks with more than $100B in assets. This will include more-robust stress testing, liquidity rules, and living wills.

Already, bank regulators will have enhanced their supervisory scrutiny of banks, focused on the interest rate and funding risks highlighted by recent events. Going forward, we expect close scrutiny of bank funding sources, liquidity risk, and concentration risk, especially in areas like commercial real estate, where regional banks are active.

Policymakers have broadly shifted their focus away from the near-term policy response, as deposit outflows have stabilized. We believe sweeping new programs, like an industry-wide deposit guarantee, are unlikely – though regulators may tweak the existing bank term funding program (BTFP) if they want to broaden its appeal.

Beyond broad-based reforms to bank supervision and capital requirements, a near-term roadmap of policymakers’ next steps has also emerged. FDIC Chair Marty Gruenberg committed this week to release a report by May 1^st that outlines policy options related to deposit insurance, which may at least kick off discussions on the suitability of the existing $250,000 insurance limit (we believe changes are unlikely). The FDIC will propose a rule in May that outlines how the FDIC intends to levy its roughly $22.5 billion special assessment on the banking industry to pay for the two failures; it’s likely the FDIC will exempt community banks from footing the bill. And the Fed will release a report by May 1^st on the supervision and regulation of SVB in the run-up to the failure.

As regional banks face a host of new capital, liquidity and operational regulatory changes, we expect a drag on profitability for years to come.

Banks will have time to comply with the new regulatory regime: We expect many of these changes (like the new treatment of AFS securities and the extension of enhanced prudential standards for regional banks) to flow through the rulemaking process, with multi-year phase-in periods. But ultimately, as regional banks face a host of new capital, liquidity and operational regulatory changes, we expect a drag on profitability for years to come.

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