Brown-Vitter Bill Image

Senators Brown (D-OH) and Vitter (R-LA) may present a bill imposing a 10 percent capital requirement on banks (capital defined as tangible common equity/total assets, grossed up for derivatives and unfunded commitments). A surcharge of up to 5 percent may be applied to banks with more than $400 Billion in assets. Proposed implementation time frame is five years.

Goldman Sachs Group, Inc. (NYSE:GS) estimates that the bill “would increase the amount of required equity in the US banking system by $1.1tn, which would drive ROE’s down to 5 percent (from 11 percent). [Goldman Sachs analysts] believe banks would likely have difficulty raising this amount and [their] analysts suggests it could reduce lending capacity by an estimated $3.8tn, or 25 percent of today’s level.” Such reduction in lending capacity is equivalent to taking JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC) out of the US banking system.

Lending capacity taken out Chart

Banks with 15 percent capital requirements (those with $400 Billion or more in assets) could de-leverage by 50 percent reducing system lending capacity by $3.8 trillion. Such banks will also raise 50 percent equity to meet new, more stringent capital requirements.

Even if global systemically important financial institutions, such as JPMorgan Chase & Co. (NYSE:JPM), Citigroup Inc. (NYSE:C), Bank of America Corp (NYSE:BAC), and Wells Fargo & Company (NYSE:WFC), broke up or reduced assets below $400 Billion, complying with the proposed bill will probably reduce earnings stream diversity and hamper funding (in case of a break up).

In an asset reduction scenario, banks will need to double their equity if they de-levered to $400 Billion. The capital requirements will be more than double the proposed Basel requirements.

Raising capital will be challenging for banks as the reduced ROE of approximately 5 percent will not be appealing to investors, as such ROE does not cover the bank’s cost of capital. Investors probably will not view bank shares as profitable investments, and the number of buyers will decline.

Goldman Sachs Group, Inc. (NYSE:GS) analysts estimate that the average global systemically important financial institution will take approximately 12 years in earnings to raise equity organically to comply with the proposed Brown-Vitter Bill. Given the 5 year proposed implementation time frame of the bill, banks may struggle to meet new capital requirements.

Even though it is unlikely that the Brown-Vitter bill may not be passed in its current form, investors should take note of its possible impact. If Congress considers passing a “watered down” version of this legislation, the impact to the banking system could still be significantly negative, according to Goldman analysts.