Global banking and financial regulators like the US Federal Reserve have recently published regulatory norms to supervise institutions deemed as Too Big to Fail (TBTF). The crux of these regulations is to contain the impact of the probable failure of such institutions from spreading to the wider financial system. Regulators hope to ensure this by imposing stringent capital requirements and mandating such institutions to publish living wills (a resolution plan of how these institutions are to be wound down in the event of a bankruptcy).
TBTF financial institutions are so large that if they fail, the resultant ripple effect can take a broad segment of the economic ecosystem several notches down. This is due to the level of cross-liabilities and inter-linkages such institutions have with each other and with the larger landscape. Thus, TBTFs must be protected from failure to the extent possible. In the unfortunate event of the failure of a Systemically Important Financial Institution (SIFI) the technical term for such organizations only governments have the financial ability to invest huge sums to fund their rescue, and this imposes a burden on the exchequer, which may or may not be recouped.
The Financial Stability Board (FSB), an international body that monitors the global financial system, has published a list of institutions classified as SIFIs. In the US, the Federal Reserve regulates such institutions as part of its Global Systemically Important Banks (G-SIB) regulations. The Fed has recently finalized rules that require G-SIBs to hold substantially more capital (sufficient to bear the cost of their failure, should the need arise) or shrink their businesses to below the threshold. The capital surcharges prescribed by the US Federal Reserve are significantly higher (at 200 bps) than the international norms.
Raising incremental capital appears to be less likely, as going forward, the return ratios of G-SIBs could be much lower than smaller banks. This means that G-SIB banks will face challenges in raising substantial capital at lowered rates of return, as these may not meet the minimum return benchmarks expected by large investors. Also, given that banks will need to compete for scarce capital with other sectors, they may find incremental capital harder to come by, if their return ratios are lower. So, the more probable outcome is that banks shrink their size either by spinning off low yielding business segments or by divesting selected loan portfolios and lines of business to other banks or non-bank financial institutions (NBFIs). The bid to deflate their balance sheets organically, that is, by discontinuing less profitable segments, will result in G-SIBs creating opportunities for alternative financial services providers like P2P lenders and online marketplaces.
Some initial signs of this are already visible. There have been announcements of asset sales by a number of banks that are classified as G-SIB, or are close to the threshold. We believe this may herald a trend of mega financial companies hiving off segments to optimize their business, focusing on select areas where they have a competitive advantage. This may also lead to unbundling of the financial supermarket business model where banks try to meet all of their customers needs and cross-subsidize different products, thus resulting in the emergence of several niche service providers. For example, there may be more players who are pure mortgage providers, equipment financiers, and so on.
This brings us to a pertinent question: which institutions will step up to occupy the space vacated by these giant banks? While some amount of business growth for smaller (non-G-SIB) banks is a given, there is also the possibility of shadow banks coming in to fill this gap and lap up the assets on offer. Shadow banks enjoy lower regulatory oversight than regular banks, which would presumably increase the fear of G-SIB regulations merely transferring the risk from large banks to the smaller, less regulated ones. In any case, a major reordering of the US financial system is the only outcome that can be predicted with any certainty, as of now.