Current capital rules for U.S. Banks require only the largest and most complex banks to include accumulated other comprehensive income (AOCI) in regulatory capital. Proposed new rules would extend this requirement to all banks over $100 billion in assets. Much of the discussion on the proposed rules has focused on unrealized losses on available-for-sale (AFS) securities. Transfers from AFS to held-to-maturity (HTM) also generate AOCI. This component of AOCI has received less attention but is even less attractive from a regulatory capital standpoint. AOCI generated from transfers to HTM are essentially locked in losses.
As I noted in an earlier post, banks already required to reflect AOCI in regulatory capital have tried to mitigate their exposure by designating more securities as HTM. These actions have a host of negative effects on IRR management and liquidity risk, but they at least reduce capital volatility. Banks can grow their HTM portfolios over time by designating new purchases as HTM. They can also speed up the AFS to HTM transition by redesignating some AFS securities as HTM. The trouble with the latter approach is that it only avoids recognizing future losses, not losses to date. The unrealized loss at the time of transfer goes into AOCI and is then accreted over the life of the security. What’s worse, the bank has essentially locked in the loss. Unlike AFS securities, the AOCI impact doesn’t go away if the market recovers.
A handful of “systemically important” banks must reflect AOCI in regulatory capital under current rules. The new rule would extend all U.S. bank holding companies over $100 billion in assets. I looked at net unrealized losses on HTM securities that are included in AOCI this second group. The table below shows those where HTM in AOCI represents more than 1% of common equity tier 1 (CET1) capital.
Schwab clearly has outsized exposure, but HTM-related AOCI levels at PNC and US Bank are also close to 10% of CET1. More significantly, higher rates mean that future AFS to HTM transfers may do more harm than good from a regulatory capital standpoint.
fers may do more harm than good from a regulatory capital standpoint.
Timing is a key consideration. HTM transfers reduce capital volatility but won’t help much for portfolios that are already considerably underwater. The table below adds unrealized losses on AFS securities to provide a more complete picture [1] of AOCI exposure levels.
[1] Does not reflect AOCI resulting from cash flow hedges, postretirement benefits, or foreign currency translation.
Including AFS-related AOCI pushes Schwab’s AOCI/CET1 to nearly 70% and US Bank’s and Truist’s to over 20%. One notable case is KeyBank, which reports zero HTM-related AOCI. However, its AOCI from AFS securities represents nearly one-third of CET1.
Options Available to Banks with Large AOCI Exposure
Banks have several options to mitigate their capital risk, ranging from efforts to strengthen their balance sheets to more cynical approaches.
Build Capital
Regulators design and revise capital requirements to alter behavior. Banks can respond to the new rules by either reducing their risk profile or building capital levels. The latter may involve reducing dividends and holding off on share repurchases. These actions won’t make AOCI go away but can reduce its impact.
Market Recovery
Market interest rates can go down as well as up. The extent and duration of recent rate increases does not preclude a bond market recovery. A bond market recovery would reduce the AOCI hit from AFS but not from HTM.
Selling HTM securities risks tainting the entire HTM portfolio. This could be an especially big deal since HTM portfolios carried at cost often dwarfs mark-to-market portfolios. GAAP permits a limited number of exceptions to the tainting rule. These include “a significant increase in industry-wide regulatory capital requirements that causes the bank to downsize.” That might be a stretch since the downsizing relates more to the denominator (total assets) but AFS recognition relates more to the numerator (level of capital). Independent auditors may still have an incentive to accommodate large clients. However, recent bank failures make deep pocketed audit firms an inviting target and the auditors might be gun shy about appearing too accommodating.
Wait it Out
The new AOCI rules would not take effect until Q3 2025 and not be fully phased in until Q3 2028. The extended phase-in gives banks a lot of time to run down their underwater investment portfolios. A key element of the waiting it out strategy is that if you’re in a hole, stop digging. That means avoid purchases of new AFS securities or at least stick to those with short durations. Even if the securities remain on the balance sheet, the reduction in their remaining maturity will pull them closer to par, even without a favorable change in interest rates. Pull to par will be less predictable for mortgage-backed securities. High interest rates have slowed prepayments on these securities to a trickle.
Work the Refs
One surefire way to prevent the adverse effects of a proposed regulation is to kill or significantly weaken the regulation. The proposed new regulation has elicited a sharply negative response from the banking industry and its lobbyists. The argument generally runs along the lines that any efforts to increase bank capital requirements will hurt the economy, especially the little guy. It’s a little early to tell whether these efforts will bear fruit but press coverage has largely adopted banker talking points.
Consider a recent article in Politico, a centrist publication that largely reflects Beltway conventional wisdom. The article discusses higher capital requirements on low downpayment mortgages and the potential impact of the new rules on widening the racial wealth gap. It takes until the 22nd paragraph for the story to point out that the rule would not affect VA or FHA mortgages and that the mortgage portfolios of large banks mainly consist of non-conforming jumbo mortgages. For reference, the nationwide jumbo threshold is currently at $726,200 and over $1 million in higher cost areas like New York, New Jersey, and the West Coast. Those facts undermine the social justice argument.
It’s not yet clear what angle the banks will take regarding AOCI requirements, but the credulous reception to their talking points thus far makes the working the refs strategy look promising for the affected banks. Unfortunately, the inability the second, third, and fourth largest bank failures in U.S. history to trigger some basic reforms is pretty dispiriting for the rest of us.