What You Don't Know About the Big Bank Capital Surcharge

WASHINGTON — For every answer international regulators give on a requirement for a large bank capital surcharge, it just feels like more questions pop up.

The Group of Governors and Heads of Supervision agreed over the weekend to force certain banks to hold between 1% to 2.5% in extra capital depending on their size, riskiness and complexity. But left unclear, among other things, was exactly which institutions will face that charge, and where in the range they will fall. We offer the following frequently asked questions in an effort to explain what's going on.

So regulators agreed to what?
In a nutshell, regulators want to force the largest, most complex, internationally active banks to hold extra capital, between 1% to 2.5% in common equity. These requirements would be on top of basic Basel III requirements, which require all institutions to hold 7% in common equity by 2019. For those keeping score, that means the largest banks would have to hold between 8% to 9.5% in common equity by 2019.

Is that good or bad for banks?
Mostly good, although it depends on your expectations. Some large banks had been fervently hoping that regulators would not institute a capital surcharge on U.S. institutions, arguing new requirements of Dodd-Frank were tough enough already.

But the chances of that happening were always slim, and regulators like Federal Reserve Board Gov. Dan Tarullo had suggested a surcharge of up to 7% at one point earlier this month. The consensus expectation had been a range between 1% and 3%, making the final announcement a little bit better for the big guys. Bank stocks were mostly up in Monday trading, which tells you investors certainly see it as better news than expected.

Who would have to pay this surcharge?
Roughly 30 banks worldwide. Of U.S. institutions, you can expect the largest banks to pay a surcharge, including: Citigroup Inc., JPMorgan Chase & Co., Goldman Sachs & Co., Wells Fargo & Co., Bank of America Corp., and possibly Morgan Stanley. That is not a definitive list, however, and other big banks are likely to be on it.

So they will all have to hold 2.5% in extra capital?
No. International regulators offered a range for a reason, and plan to differentiate based on five factors: size, interconnectedness, lack of substitutability, global activity and complexity. Even the banks I mentioned above don't know where regulators will put them on that range. Early speculation puts Citi, Chase, and possibly BofA in that first tier facing the 2.5% surcharge, but this is far from settled. Regulators will still have to make that determination, and could conceivably put every institution in a different bucket.

Could any of them face even higher capital requirements?
Yes, although that's not likely in the short term. Regulators warned they could assess a 1% extra surcharge if big banks continue to grow bigger. Will they actually make do on that threat? Some are skeptical, but the uncertainty makes some bankers nervous. It's clearly intended as a message.

Greg Lyons, a partner at Debevoise & Plimpton LLP, called it a "Sword of Damocles over the big banks," while Karen Shaw Petrou, managing partner of Federal Financial Analytics, called it a "penalty box."

It's also possible that U.S. regulators could decide the surcharge is not high enough for domestic banks and raise capital requirements accordingly. That doesn't seem likely for now, but it's worth remembering that both the Fed and Federal Deposit Insurance Corp. favor more, not less, capital.

Would any other big banks face these requirements?
International regulators have set the bar high for which institutions are considered global, systemically important banks, called G-SIBs. Some countries, like Japan or Germany, may find few of their banks qualify because they are either not globally active or are not complex.

For U.S. banks, some observers expect regulators to apply a smaller surcharge to banks that are considered systemically significant under Dodd-Frank — those with at least $50 billion of assets - but which do not quite reach global significance.

"Presumably, it is going to be somewhat below what the G-SIBs are holding, but it's not clear yet," said Lyons. "I've heard rumors of a 0.25% to 0.75% surcharge, but we don't know."

Is contingent capital included in the capital surcharge?
No, at least not right now. U.S. regulators fought back a push from European regulators to include contingent capital as part of the extra capital requirements.

The press release on Saturday, despite saying regulators want to continue to look at the issue, says the surcharge will be tangible common equity. It seems clear the issue is still open for debate, but for right now U.S. regulators are winning it. If countries on an individual basis want to include contingent capital above the required levels, they can do so, but for the surcharge, it doesn't count.

Could different countries implement this requirement in different ways?
Yes. Keep in mind that the definition of capital can fluctuate and regulators have to assign risk weightings to various assets to determine final requirements. Regulators have yet to reveal their methodology to the public. Adding more anxiety among bankers is whether different regulators in different countries may tackle that issue differently. That could mean big discrepancies between what a globally important large bank faces as a capital requirement in one country versus a similar institution in another.

So this makes the system safer, right?
Well, we could debate the relative merits of higher capital versus tougher supervision, but what should worry you is this: these requirements do not touch globally significant nonbanks. So, for example, had this surcharge been in place 10 years ago, it would not have applied to Fannie Mae or Freddie Mac, institutions that the government had to save because they were so economically critical. Going forward, the new requirements do not apply to hedge funds or other big market players that do not technically fall under the definition of bank.

"The backward looking exclusive focus on banking is a significant failure," said Petrou. "It ignores the origins of systemic risk in the past like Fannie and Freddie and those looming now as the shadow system continues to outpace traditional banking in size and scope."