Additional interest rate cuts will reduce the strain of unrealized losses and bring greater balance sheet flexibility to regional banks, which are sitting on record-high capital levels.
For the second quarter of 2024, large regional banks' aggregate common equity Tier 1 (CET1) ratio exceeded 13% for the first time since 2015, according to data compiled by S&P Global Market Intelligence. Since the Basel III capital framework took effect Jan. 1, 2014, the group's highest aggregate CET 1 ratio was 13.84% in the fourth quarter of 2014.
The more recent elevated capital is driven by the large regionals preparing for proposed capital rule changes, as well as addressing credit quality concerns in commercial real estate (CRE), said Vinnie Badinehal, head of the financial institutions group at RBC Capital Markets. As part of Basel III Endgame re-proposal recommendations, the large regional banks are expected to hold about 3% to 4% more regulatory capital as a result of including unrealized gains and losses on securities, a key area of focus viewed as a root cause of the large bank failures in 2023.
Unrealized losses grew and put pressure on banks' balance sheets because sharp interest rate hikes shrank the market value of the securities they purchased when interest rates were low. As the interest rates go down, and more of those securities are approaching their maturity dates, those unrealized losses will decrease, Badinehal explained.
"I wouldn't necessarily believe that people have excess capital based upon their unrealized losses and exposure to CRE, but as these unrealized losses and credit issues play itself out ... there is a possibility that, in a year from now, or two years from now that they might have more capital at that time, and could deploy that for buybacks and/or M&A," Badinehal said.
The growing capital bases have in part helped assure bank stock investors, and many are shifting the focus to banks' earnings power in anticipation of more rate cuts, since a number of the large regionals have been asset sensitive, said Frank Sorrentino, managing director in investment banking at Stephens' financial institutions group.
"I feel like investors are less focused on balance sheet and credit concerns, and now trying to find the companies that are growing revenue and ultimately can expand earnings," Sorrentino said.
Prudent in the near term
The flexibility will not be unlocked in the near term, and capital formation will continue to be a theme as large regionals report third-quarter earnings releases. Most of the large regionals will continue to be prudent in capital deployment as the effect of interest rate cuts has not fully kicked in.
The Federal Reserve's 50-basis-point rate cut in September has helped relieve some burden, but not yet by a tremendous amount, said Scott Hildenbrand, head of depository fixed income at Piper Sandler. Banks' bond portfolios typically have a three- to five-year weighted average duration, and rates on that part of the yield curve have gone higher slightly because of the economic outlook, Hildenbrand said.
"I think we're getting close to a comfortable place, but we're not there yet," Hildenbrand said.
The exposure to CRE loans is another reason to be mindful of capital. "It's not been as bad as people said it would be, but there's still a meaningful concern for certain classes of CRE and it will play itself out over the next few years," Badinehal said.
Most of the banks that sparked concerns among investors due to the CRE exposure have been smaller regionals or community banks, according to Market Intelligence data. New York Community Bancorp Inc. and Valley National Bancorp are among the few banks with over $50 billion in total assets that have the CRE exposure weighing heavily on their stock prices.
If the large regionals do reach a point with excess capital to deploy, there will be interest in M&A, technology investments and more balance sheet restructuring, said Gregory Lyons, a corporate partner at Debevoise & Plimpton LLP.
"I do feel confident that they would like to do more M&A, and I think they will deploy some of the capital for that purpose," Lyons said in an interview. "They also are spending it on fintech, on technology customers are always demanding, and also, frankly, to continue to clean up their balance sheets."
Building capital buffer
For the large regionals with over $100 billion in total assets, if accounting for the additional capital for unrealized losses as the new rules proposed, the group median of the CET1 ratio would be 10.10% in the second quarter, compared to the latest regulatory minimum of 7.65%, according to calculations by Market Intelligence.
Banks typically maintain capital levels at least 1 to 2 percentage points above regulatory minimums to avoid the complexities of falling under, said Chen Xu, counsel at Debevoise & Plimpton LLP. In addition, given that the sector just came out of the 2023 turmoil, it is not out of the ordinary if banks are expected to maintain an even stronger capital buffer.
"In light of the turmoil of the regional banking industry over the past couple of years, I would think the regulators also would expect a bit more of a buffer to make sure that they are prepared if any calamity hits once again the market," Xu said in an interview.
Restructuring balance sheets has been a theme in capital deployment. KeyCorp, whose CET1 in the second quarter would have been on the borderline accounting for unrealized losses, secured a $2.8 billion minority investment from Bank of Nova Scotia in August, in part to bump KeyCorp's CET1 ratio. KeyCorp has also sold $7.0 billion of available-for-sale securities in September for an expected loss of $700 million in the third quarter.
Truist Financial Corp. is another bank that boosted capital lately, by the sale of its insurance unit in May 2024 for $12.6 billion in transaction value. The main goal for the capital is to reduce unrealized losses and comply with the widely expected new capital rules, said William Rogers, Truist's executive chairman and CEO, at an investor conference in September. It intends to stay in the 10% range for the CET1 ratio, Rogers said.
M&T Bank Corp., sitting on ample capital, started buybacks in the third quarter and plans more in the fourth quarter, CFO Daryl Bible said at an investor conference in September.
M&T is currently focused on organic growth, risk management, improving resiliency and optimizing costs, Bible said. If it were to consider M&A, it would likely look for opportunities in its existing markets in the Northeast and mid-Atlantic, Bible said.
Other capital considerations
With all eyes on the Basel III Endgame re-proposal, industry experts pointed to several items that have changed large banks' capital management practices.
Large regionals' appetite for a type of securitization instrument, namely credit risk transfer (CRT), has declined, because the proposal would require banks to hold capital against this type of securitization, said Matthew Bisanz, a partner at Mayer Brown. Large regionals have been using CRTs to sell risks in loans to institutional investors, touting the benefits of reducing risk-weighted assets, while holding the loans on their balance sheet.
"That's why, I think, you saw some banks either not do a CRT, or they did a shorter duration CRT," Bisanz said.
In addition, one criticism of accounting capital for unrealized losses is that it would make banks' capital bases more volatile, Xu said. Higher capital ratios may simply be driven by fewer unrealized losses or unrealized gains, without any changes in the fundamentals, so that the positive capital trend could be misleading.
While the rule changes only address risks of unrealized losses in available-for-sale securities, Federal Reserve Vice Chairman Michael Barr also highlighted similar risks in held-to-maturity (HTM) securities in a speech Sept. 26. But new capital requirements on HTM securities are unlikely because that would run counter to the primary accounting principle of HTM securities, Xu said.
"There are liquidity rules about whether or not held-to-maturity securities can count as liquid assets, because you may not be able to monetize them as easily. But for capital purposes, it would be very surprising to see any changes there actually," Xu said.
