A new Federal Reserve proposal to ease annual "stress tests" designed to keep big banks like JPMorgan Chase & Co. (JPM - Get Report) and Goldman Sachs Group Inc. (GS - Get Report) from failing could be bad news for bondholders.
Moody's Investors Service, which analyzes the probability of bond defaults, says the new proposal from Randal Quarles, the Fed's vice chairman for bank supervision, is a "credit negative." In the lingo of credit-rating firms, that means a bond default is incrementally more likely.
Goldman shares fell 5.8% to $210.02, their biggest decline in more than two years, after a Goldman executive was identified as a conspirator in a scheme that embezzled $2.7 billion from 1MDB, Malaysia's state investment fund, which was a Goldman client. The Fed proposal is not regarded as a negative driver for the stock.
In recent years, the Fed has used the annual stress test, known formally as the "Comprehensive Capital Analysis and Review," to prod banks to operate with lower risk. Big-bank CEOs have been pushing to operate with more debt, or leverage -- so they can maximize shareholder returns by paying out more of their capital in the form of higher dividends and stock buybacks.
While such moves can increase short-term profitability, they also theoretically bring a higher risk of a bank failure, since the increased borrowings leave a slimmer margin of error in the event of steep loan losses or a trading mishap.
"Any regulatory initiative making it easier for banks to distribute capital to shareholders would be negative for creditors," Moody's wrote on Monday, Nov. 12, in a report.
Quarles, a former financial-industry lawyer and private-equity executive, was appointed last year by President Donald Trump as the Fed's person in charge of overseeing the biggest banks. Just a decade after the mortgage crisis of 2008, during which the global financial system nearly collapsed, Trump and officials in his administration have pledged to loosen regulations in the banking industry and other sectors, arguing that the steps will promote faster economic growth.
At issue is how much capital banks hold -- the buffer of extra assets they're supposed to keep on hand to protect depositors and ward off a government-funded bailout. But lower capital just means higher leverage.
"As firms become more resilient, they may no longer need to build capital to support their current level of risk-taking," Quarles said Friday, Nov. 9, in a speech in Washington at the Brookings Institution.
Among the changes proposed by Quarles in his speech: Banks will no longer fail the annual stress test for tripping a "supplementary leverage ratio" -- a simple test that serves as the most basic gauge of a bank's borrowing level. Under that test, banks can't borrow more than 97% of the value of their assets.
According to Quarles, banks that trip the test in future years would avoid such public failures and instead be quietly urged, in secret, closed-door supervisory discussions with bank executives, to reduce their risk, Quarles said.
But according to Moody's, the leverage ratio "has functioned well as a backstop when supervisory risk measurements have proved insufficiently reliable."
"Therefore, insofar as removing the post-stress leverage requirement reduces capital requirements for banks, it would be credit negative," the Moody's analysts wrote.