Analysis-Regional banks brace for tougher capital rules, get relief from Fed cuts

By Saeed Azhar

(Reuters) – U.S. regional banks preparing for higher capital requirements will get some relief from the Federal Reserve’s jumbo rate cut.

As lenders gear up to report third-quarter earnings this month, monetary easing will help regional banks to shrink paper losses on bond portfolios that were seen as a drag on future profits.

The changes were proposed as U.S. regulators aim to tackle weaknesses that caused three regional banks to fail last year and fueled turmoil in the financial industry. The Fed estimated the changes would equate to a 3% to 4% increase in the amount of capital that mid-sized banks were required to hold.

“The impact for these banks initially could be quite higher from” proposed changes in capital rules, said David Fanger, Moody’s (NYSE:MCO) senior vice president Moody’s Ratings for financial institutions group.

In the short term, however, the rate cut “alleviates some of the fears on capital” for regional lenders, which will be the “disproportionate beneficiaries” from looser monetary policy, said Chris McGratty, an analyst at Keefe, Bruyette & Woods.

  At issue are banks’ bond holdings, which eroded in value as the Fed raised rates from 2022. Lenders haven’t yet lost money on the bonds because they still hold the securities, which could appreciate in value as the Fed cuts, narrowing potential losses.

Silicon Valley Bank failed in March 2023 after it lost money from selling U.S. Treasuries.

Regional banks are in a much stronger position after last year’s woes, said Ken Usdin, an analyst at Jefferies.

“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.”

For instance, Comerica (NYSE:CMA) could benefit from the rate cuts, putting it into an excess capital position by 2027, McGratty said. 

Comerica declined to comment. It will hold a conference call on Oct. 18 to discuss earnings.

Other banks are also taking steps to bolster their capital or rejig their securities books.

KeyCorp (NYSE:KEY) had $3.7 billion in unrealized losses on its available-for-sale (AFS) securities on August 9. The holdings are classified as AFS because the bank has the option to sell those bonds or securities before they mature.

The lender recently took steps to boost capital and trim its securities. When it sold a $14.9% stake to Canada’s Scotiabank in August and in September, it offloaded about $7 billion of low-yielding investments that would result in an after-tax loss of about $700 million in the third quarter.

The divestment reduced Key’s paper losses to $3.0 billion, and it projects these losses to shrink even further, to $1.6 billion by the end of 2026, based on the forward interest rate curve, the company said in an email. Key will give an update during its earnings on Oct. 17.

The company’s shares have risen over 17% this year, surging in the third quarter after a decline in the second. Other regional bank stocks have also rallied.

PAPER LOSSES

More broadly, U.S. banks’ unrealized losses on available-for-sale and held-to-maturity securities have declined significantly from the peak of $690 billion two years ago, but still stood at $513 billion in the second quarter, according to the Federal Deposit Insurance Corp.

Fitch Ratings predicted the Federal Reserve will cut rates by 175 basis points through 2025, which will further reduce paper losses.

Banking giants such as JPMorgan Chase (NYSE:JPM) and Wells Fargo are already required to set aside money to account for their unrealized bond losses. They kick off earnings season on Friday.

Mid-sized lenders had so far been spared from higher capital requirements, but that could change if the new rules come into force.

The Basel endgame proposal has been rolled back to become less onerous for the largest banks, which are already the most tightly regulated, said Mike Mayo, an analyst at Wells Fargo. Meanwhile, smaller lenders “still have to pay an extra toll,” he said.