Yesterday, the Federal Deposit Insurance Corporation (FDIC) published a notice of proposed rulemaking (NPRM) to increase the Supplementary Leverage Ratio (SLR) for Advanced Approaches Banking Organizations to 5% for bank holding companies (BHC) and to 6% for U.S. bank subsidiaries.

Federal Deposit Insurance Corporation FDIC

Affects On Financial Institutions

This rule affects the 8 globally systemically important financial institutions (G-SIFI) in the U.S.: Bank of America Corp (NYSE:BAC), The Bank of New York Mellon Corporation (NYSE:BK), Citigroup Inc (NYSE:C), Goldman Sachs Group Inc (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), Morgan Stanley (NYSE:MS), State Street Corporation (NYSE:STT), and Wells Fargo & Co (NYSE:WFC). The NPRM notes that each institution’s current capital strengthening initiatives “appear” to be generally in line with achieving the 5% SLR by its effective date of January 1, 2018 based on the Comprehensive Capital Analysis and Review (CCAR) as of September 30, 2012.

Edwin Groshans says in a new report that they view this as a very positive statement by the regulators as capital return expectations should not have to be lowered for the top five institutions: Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C), Goldman Sachs Group Inc (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), and Wells Fargo & Co (NYSE:WFC). The Bank of New York Mellon Corporation (NYSE:BK), State Street Corporation (NYSE:STT), and Morgan Stanley (NYSE:MS) have the lowest Tier 1 leverage ratio under Basel I rules and could be at risk of having to modestly dial back future capital distributions or derisking the balance sheet to meet the proposed increase in the SLR.

But the math is not so simple, and is the subject of debate.  If adopted, the proposal would require a BHC to meet a 5% minimum leverage ratio and insured depository subsidiaries of a G-SIFI would need to meet a 6% supplementary leverage ratio to be well capitalized. The proposed minimum BHC leverage ratio was lower than we expected (5% versus 6% expected). However, Brian Kleinhanzl of KBW, Inc. (NYSE:KBW) estimates that only Bank of America Corp (NYSE:BAC) and Wells Fargo & Co (NYSE:WFC) would have met a 5% BHC leverage ratio as of 1Q13.

David Konrad, CFA of Macquarie notes

Impact Of FDIC Leverage Ratio Proposal

  • Be Careful What You Wish For. Although we agree with the concept of the leverage ratio to provide a safeguard against banks’ potential optimistic estimates of risk weighted assets, we also believe that a too conservative view of the calculation of assets in the supplemental leverage ratio may contract liquidity in the market. For example, we believe that the banks may improve their leverage ratio by shrinking matched Fed Funds and Repo desks that may not be able to justify carrying 5% capital. In addition, we question the need for banks to hold 5% capital on deposits that are held by the Fed. Although banks will need to manage Basel III liquidity requirements, we believe these three categories will be first to be managed down. For example, 22% of  JPMorgan Chase & Co. (NYSE:JPM)’s balance sheet is in cash at banks and/or Fed and their Fed Funds/repo desks. These categories would account for approximately 60 basis points in the leverage ratio.
  • Citi is Closer Than First Appears. Although our rough estimate shows Citigroup Inc (NYSE:C) in the mid-4% range for the supplemental leverage ratio, we note the sale of MSSB to Morgan Stanley (NYSE:MS) this quarter will improve the ratio by approximately 40 bps. In addition, we believe the continued run-off of Citi Holding assets and continued strategic sales of certain international locations will allow Citi to surpass this 5% hurdle over the next few quarters.
  • Morgan Stanley’s Ratio May be Backward Looking. MS comes out at approximately 4.4% in our estimated leverage ratio; however, we believe the factors driving the ratio below the proposed 5% threshold are excess liquidity (company already above LCR requirement) and derivatives exposure. That said, Morgan Stanley (NYSE:MS) is currently undergoing major changes in its business model by taking capital out of the FICC trading business and putting capital into the retail brokerage business. As a result, we expect continued run-off of the notional derivative exposure. More important, we believe management may rethink the need to carry 23% of its balance sheet in the Global Liquidity Reserve considering business mix and the $55 billion of new deposits acquired from Citi in the MSSB purchase this quarter. The ability to reduce the GLR would not improve NIM but also the leverage ratio.

Credit Suisse analyst Moshe Orenbuch believes the answer to the question how will banks manage to the proposed leverage rules?

Leverage Ratio FDIC

Banks Under The Target Leverage Level

For those banks currently below the target leverage levels, we think that balance sheet management coupled with internally generated capital should be sufficient to meet minimums. We would expect Citigroup Inc (NYSE:C) to be positioned to achieve a 5% BHC leverage ratio by YE 2013. And for Morgan Stanley (NYSE:MS) and The Bank of New York Mellon Corporation (NYSE:BK), we think they could achieve target levels well before the compliance date of January 1, 2018 although we acknowledge the market may expect compliance sooner. We would expect active management to reach the new leverage rules in relatively short order—similar to the banks accelerating compliance with B3 Tier 1 common minimums well before full implementation date.

Given a substantial increase in capital over the last few years, we estimate that these banks to pursue balance sheet optimization to meet new leverage requirements. We estimate that the redefined denominator for leverage exposure (inclusion of credit commitments and derivatives, etc.) leads to 36% inflation relative to the current definition of average assets—leaving banks the opportunity to optimize this portion of the “asset” base without affecting on-balance sheet assets.

We estimate that about $2.6 trillion of the G-SIBs assets receive a 0% risk-weighting under current Basel 1 rules. These items include cash, Treasuries and other assets considered to have little or no risk. We estimate that if these asset categories were eliminated from the calculation of total assets in the leverage ratio, the median BHC supplementary leverage ratio would be 6.4% as of March 31, 2013 versus our current estimate of 5.1%. While there was no mention of eliminating 0% RWA’s from the leverage ratio denominator definition, we would expect regulators to receive feedback from banks during the 60-day comment period—likely to include comments about the rationale for holding capital against asset classes such as cash. This is an area that could possibly see some softening in the final rules.

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