Tougher Capital Rules for Regional Banks Means More Pressure on CRE Lending

Federal regulators are about to require regional banks to increase their capital reserves against weaknesses in how the institutions carry and account for interest-based assets, according to a Reuters report. Reportedly, the Federal Reserve has estimated this would be a 3% to 4% increase in the amount of capital the mid-sized banks would need to hold.

Increasing capital requirements is typically an irritating topic for banks. It means they take money otherwise available for lending, investing, or meeting liabilities like deposits and make it unavailable even though it sits in the vault, so to speak.

This goes back to the implosion of three regional banks in early 2023: Silicon Valley Bank, Signature Bank, and First Republic Bank.

In 2023, the late Charlie Munger, Warren Buffett’s former partner at Berkshire Hathaway, told the Financial Times, “But trouble happens to banking, just like trouble happens everywhere else. In the good times, you get into bad habits. When bad times come, they lose too much.” The biggest of bad habits was likely that banks became accustomed to low interest rates from the Fed and they went heavy on Treasury and government-sponsored enterprise mortgage-backed bonds to keep the money they were making because there were fewer opportunities to lend.

Bonds are priced with consideration of interest rates. When rates go up, already existing bonds with lower rates are now worth less. Banks had two ways to account for the value of the government debt they held. One was available-for-sale (AFS), which meant they weren’t tied up and regularly repriced to market moves. The other was more popular because it didn’t undercut value on balance sheets, and was held-to-maturity (HTM), but that assumed the bonds weren’t to be sold until when they matured.

What those troubled banks learned before they ultimately closed for insolvency was that if you buy short-yield bonds and designate them HTM, you’d better hope that interest rates don’t rise. But they did when inflation kicked up and the Fed eventually raised interest rates. That sent yields up and the HTM bonds sharply dropped in value. When there was a big move by large depositors moving their money out, there wasn’t enough capital to safely cover the withdrawals. Selling the large amount of HTM bonds wouldn’t work because they had lost so much value.

So, bank regulators want to see more capital on hand to ensure that banks will remain solvent in case of problems. Banks will make some gains as interest rates are reduced, restoring lost value in bond holdings.

“As you look forward over the next couple of years, banks are going to see upwards of at least a 25% further recovery of those unrealized losses, part of which is going to get accelerated into this quarter,” Ken Usdin, an analyst at Jefferies, told Reuters.

But will cuts keep happening/? Some like Apollo Global Management chief executive officer Marc Rowan think that more may not be necessary. And Fed Chair Jerome Powell recently said, “Ultimately, we will be guided by the incoming data. And if the economy slows more than we expect, then we can cut faster. If it slows less than we expect, we can cut slower.”

There is still a lot of uncertainty. The 10-year Treasury yield has been increasing again, meaning that investors expect higher rates in the longer term. Bank-held CRE loans still face headwinds. Adding more bank capital to reserves means less for loans.