The Fed Taketh, Congress Giveth?

Bank rule changes have popped up from both ends of the National Mall in Washington, DC in recent days, arguably cutting in opposing directions. On one end, Congress, in its zeal to get out of town for the holiday break, duct-taped a tiny Dodd-Frank amendment into a massive bill seeking to keep government from shutting down (entertainingly dubbed the "cromnibus-continuing resolution and omnibus bill"). On the other, the Fed continued its quest to make the biggest banks (again) boost capital. Both grabbed a bunch of headlines and even some punditry flak. But these are both widely expected moves-not surprises for good or ill. They may create some winners and losers, but they don't create big headwinds for Financials stocks or markets overall.

First, the Dodd-Frank amendment-your typical "we can't ever pass this on its own, so we'll duct-tape it to something essential and see what happens" rider. The amendment would water down a Dodd-Frank provision requiring banks to push some derivatives trading to non-FDIC-insured units. The logic underpinning the rule goes like this: Derivatives are "risky," some institutions that received bailouts in 2008 had some derivatives blow up, and moving them out of government-insured units keeps taxpayers off the hook for banks' risky behavior. Banks have long hated this, arguing it impedes flexibility and jacks up operating costs unnecessarily-and decreases oversight (and therefore increases risk) since non-FDIC-insured units get fewer government eyeballs.

Ergo, the rider to water it down. Banks are happy. Politicians and pundits seeking to prevent another 2008 less so. In our view, the change is really a whole lot of nothing. It probably does reduce banks' costs incrementally, but the added flexibility is likely overstated. Most swaps (almost 95%) were still allowed to stay in-house-interest rate swaps, foreign exchange and cleared credit derivatives were never pushed out. All things banks use for hedging normal operations. Only equity and commodities derivatives, uncleared credit default swaps and so-called structured finance swaps had to move. Under the proposed change, only structured swaps used for hedging and risk management get a reprieve. Which seems logical and incremental-the net notional value outstanding is tiny. Plus, all that shifting doesn't change much from a bailout standpoint. Non-bank subsidiaries could still get government support if the Fed deems necessary for the good of mankind. Besides, the push to move certain activities to a subsidiary as a protective move is untested theory that largely presumes a parent company would be totally unaffected by the goings on. So this is the elimination of a rule that wouldn't have much impacted 2008 anyway.

The Fed's move is the reverse-a new rule that wouldn't have prevented 2008 if it were in place then, continuing what seems largely like a regulatory game of whack-a-mole. On Tuesday, The Fed announced a new capital rule affecting the biggest US banks-the "too big to fail" (TBTF) surcharge, another long-known Basel III provision. The Fed's rules, as widely telegraphed for over a year, are tougher than the international requirement, requiring TBTFs to hold an additional 1% to 4.5% of risk-weighted assets on top of the 7% minimum for everyone. The calculation is more art than science. Banks with assets over $50 billion must determine their TBTF-ness based on six "indicators of global systemic risk":

• Size
• Interconnectedness
• Substitutability
• Complexity (multiple, diverse business units)
• Cross-jurisdictional activity (global reach)
• Use of short-term wholesale funding (commercial paper)

Currently eight banks qualify and must either raise money or get smaller. Regulators would prefer the latter, but banks are free to choose, and most assume they'll just raise the cash. Particularly since the entire shortfall is a whopping $20 billion, and Vice Chair Stanley Fischer let slip (oops) only one bank needs to raise much capital-and the rule phases in from January 1, 2016 to January 1, 2019 (25% raised by 2016, 50% by 2017, etc.). If you are a normal person, $20 billion is big. If you are one of the world's biggest banks, it is small. For the bank in question, it is $0.3 billion below total net income over the past four quarters. Which makes it seem safe to say they can be compliant simply through retaining earnings, not cutting lending or issuing new stock (or shrinking, if they don't want to). Shareholders might not love seeing lower dividends, if it comes to that, but banks already lack dividend flexibility since the Fed must greenlight every planned dividend when they hold stress tests. In short, the changes here too are minimal.

Though there is an irony. Banks are penalized for relying on short-term funding, because regulators think it's more prone to flight than deposits (a false assumption. See Cyprus and Spain.) Meanwhile, another rule, the Liquidity Coverage Ratio, changed the risk-weighting on large deposits from hedge funds and similar institutions, making them costlier for banks to hold and prompting banks to charge fees for them. Which probably makes those institutions less likely to park funds with banks, reducing banks' deposit base and making them more reliant on wholesale funding and therefore TBTF-ier. Not a huge headwind! Just an irony and the latest example of regulations' unintended consequences.

Overall, these largely amount to a lot of nothing for banks (provided they even happen-the Fed's rule is pending public comment, and Cromnibus still needs Senate and Presidential^[i] approval). They get additional clarity, which is nice, but the industry has long expected this week's changes.

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[i] The Presidential rubber stamp seems assured, but hey, you never know.