Large U.S. banks' risk scores jumped in the first half as a pandemic rush of government stimulus has inflated balance sheets, pushing up a gauge regulators use to determine minimum capital levels.

JPMorgan Chase & Co., Bank of America Corp. and The Goldman Sachs Group Inc. all face potential 50-basis-point increases in capital surcharges, relative to year-end 2020 measurements, according to S&P Global Market Intelligence analysis. In total, surcharges — which use year-end figures and are implemented with lag — are on track to rise at seven of the eight U.S. global systemically important banks, or GSIBs. Higher capital ratios could hurt profitability and limit lenders' ability to make shareholder payouts.

The rising scores are partly the result of surge in deposits, and the swollen balance sheets have made the supplementary leverage ratio, a separate measure of capital adequacy, a binding constraint for several banks. That this accumulation of safe assets increased banks' perceived riskiness highlights a flaw in how the regulatory system equates size with jeopardy, said Luigi De Ghenghi, a partner at Davis Polk.

"[A bank's size score] winds up increasing substantially as your balance sheet increases, irrespective of whether your balance sheet is increasing because you've got all sorts of new deposits coming in that fund U.S. Treasurys or whether your balance sheet is increasing because you're making investments in higher-risk equity exposures," he said.

Total size is one of a number of factors used to calculate systemic risk scores. Others include borrowing and lending to other banks, exposures to complex derivatives and hard-to-value assets. The risk scores determine large banks' capital surcharges, which are added to minimum capital ratios and a stress capital buffer.

Bank of America and Goldman Sachs declined to comment on risk scores when contacted by S&P Global Market Intelligence. Wells Fargo & Co., which expects its surcharge to drop, also declined to comment. JPMorgan spokesperson Patricia Wexler wrote in an email that the Fed's scoring method was calibrated based on 2013 data and has not been adjusted for the growth over the last two years, mentioning both the excess deposits and the government's quantitative easing program.

"All banks grew over this period," Wexler wrote, noting the framework was designed to normalize the impact of default between GSIBs and non-GSIBs. "The relative measures are about the same, but yet the GSIBs have been taking higher capital requirements."

The Federal Reserve is aware of the issue as they acknowledged in the 2015 final rule, writing that lenders could be pushed into higher capital buckets simply because they were growing along with the economy. They also then said that they would "periodically reevaluate the framework to ensure that factors unrelated to systemic risk do not have an unintended effect."

The Fed has already shown some flexibility regarding the impact of government stimulus measures on banks' perceived riskiness. It relaxed leverage ratio rules due to distortions caused by the crush of deposits, thought that change expired in March. Lenders are still grappling with this issue, which has both increased systemic risk scores and pushed several banks against the minimum capital requirements prescribed by supplementary leverage ratios, which measure common equity and other Tier 1 capital against on- and off-balance sheet exposures without risk weighting.

"We're hopeful that those types of changes to regulation kind of play out in a way that demonstrates some understanding for the underlying drivers there," said Citi CFO Mark Mason at a Sept. 14 investors conference.

The industry is also optimistic that remarks by regulators about the strength of prevailing capital levels — and stress tests that gave banks a clean bill of health — open the way to adjustments of the rules that will keep requirements from getting tougher. Fed Chairman Jerome Powell said in June that when leverage ratios become binding, they can perversely influence banks to load up on risky assets and cut lower-risk assets. If a bank is constrained by its leverage ratio, it cannot rely on asset growth to generate profits so the institution might rotate out of low-risk assets and into higher-risk ones to increase returns.

"We're looking hard at the issue," Powell said.

But the timing of any potential changes remains unclear as a transition to new regulatory leadership proceeds under the Biden administration, with the president approaching decisions about whether to renominate Powell as chairman and his pick for the central bank's top supervisory official. The Fed declined to comment.

Higher scores, higher surcharges

In aggregate, the U.S. GSIBs' Method 2 systemic risk scores — a framework designed by the Fed and used in addition to an international standard — increased by about 307 points, or 7.6%, in the first half of 2021, led by a jump of about 82 points in the category for cross-border claims and obligations, according to an analysis by Market Intelligence. The next-highest increase was a 68-point increase in the complexity category, which covers factors such as over-the-counter derivatives. The raw size category increased about 51 points.

JPMorgan Chase has said it will be challenging to avoid a higher capital requirement. The bank's current surcharge is 3.5%, but its 2020 year-end score pushed it into the 4% bucket and its second-quarter score suggests a 4.5% surcharge. "As you know, that's quite a seasonal number. So it's still possible to get under 4.5% for the end of this year," CFO Jeremy Barnum said in July. "But we have to acknowledge an elevated probability, I would say, of landing in the 4.5% bucket this year, but the 4.5% bucket would be binding in 2024."

Capital surcharges based on year-end 2020 scores are also higher than those currently in effect at Citigroup Inc., The Bank of New York Mellon Corp. and State Street Corp., according to Market Intelligence data. The capital surcharges in effect are based on year-end 2019 scores.

Wells Fargo, which is subject to a cap on its assets until it fixes governance and oversight issues to the satisfaction of the Fed, is the only U.S. GSIB headed for a decline in its surcharge from the 2% in effect.

Banks facing higher surcharges have room to maneuver. Federal Reserve research has found that banks tend to manage down OTC derivatives toward the end of the year when the scores are officially calculated. Moreover, new surcharges using the Fed's scores go into effect with a lag of two years, and banks that can avoid the increase by lowering their risk scores in the interim. For example, JPMorgan's surcharge was 4.0% at year-end 2020, and that higher capital ratio will become effective Jan. 1, 2023, unless the bank's score drops in the 2021 year-end calculation.

The Bank Policy Institute, a lobbying group for big banks, is pushing to adjust the GSIB scores to account for economic growth. Analysis from the lobbying group has shown such an adjustment would have lowered GSIB scores. And the Financial Services Forum, which represents the eight U.S. GSIBs, has argued against the use of short-term wholesale financing in the Fed's Method 2 scoring.

Leverage ratios pinch

GSIB surcharges are not the only regulatory requirement affected by the deposit surge. Expanding balance sheets have also put pressure on the supplementary leverage ratio, or SLR, at the largest institutions. The SLR is not affected by incremental changes in systemic risk scores. While banks that qualify as GSIBs face a higher SLR hurdle, the surcharges that move higher alongside the risk score are only applied to other capital ratios such as the risk-weighted common equity Tier 1 capital ratio.

Balance sheet growth has made the SLR rule the binding constraint at JPMorgan Chase, BofA and Morgan Stanley, according to analysts at Jefferies.

The SLR measures common equity and other Tier 1 capital as a percentage of on- and off-balance sheet exposures, without risk weightings. The GSIBs are subject to a 5% minimum, and other banks with more than $250 billion of assets have a 3% minimum. Regulators temporarily excluded Treasurys and reserves from the calculation during the pandemic.

Leverage ratio concerns have added urgency to banks' efforts to contain deposit inflows. BNY Mellon CFO Emily Portney said Sept. 14 that her bank had accelerated deposit reductions as it works to move clients toward alternatives including direct investments in repurchase agreements and commercial paper.

Similarly, State Street CFO Eric Aboaf said Sept. 13 that "we've been able to gently bring some of those deposit levels down, and that obviously puts us in a comfortable position on Tier 1 leverage, on not needing to change the capital structure too much."