For the biggest U.S. banks, the nerves this year come after the exam. Large lenders just breezed through annual stress tests administered by their main regulator, the Federal Reserve. Now firms like JPMorgan, State Street, Goldman Sachs and Citigroup are bracing for new rules that fortify them against future catastrophes, at a punishingly high cost.

Judging by Wednesday’s test results, U.S. banks are strong enough to withstand a sharp recession without their capital ratios – essentially equity as a percentage of risk-weighted assets – dipping into the danger zone. This year’s checkup, the first overseen by the Fed’s new supervisory chief Michael Barr, modeled what would happen if U.S. unemployment hit 10% and house prices plunged nearly 40%, among other things. The result: $541 billion of losses, but still-sufficient capital at all 23 lenders.

Stress tests are onerous, but they’re a trifle compared with the snowball of red tape rolling in the industry’s direction. In the next few weeks, the Fed and other regulators are due to unveil reforms that align U.S. lenders with international standards set by the Basel Committee on Banking Supervision. These are part of a package of reforms known as Basel III, but hefty enough that executives dub them Basel IV. JPMorgan boss Jamie Dimon has described rising capital requirements as “bad for America.”

One reason executives are anxious is that the new rules – assuming they cleave to the Basel principles – will zoom in on activities U.S. banks are good at. Take securities trading. Banks following the new approach would tot up the exposures of each individual desk, a more granular approach than today, and could lose the potential benefit from different units running risks that cancel each other out. At Goldman Sachs, this shift alone could knock 1.1% off the firm’s capital ratio, Morgan Stanley analysts estimate. That’s equivalent to shrinking the Wall Street giant’s equity by $7 billion.

Another big change is the measurement of operational risk – regulator-speak for messing up. The Basel calculations size up this risk by heavily weighting revenue from areas other than lending and trading, penalizing fees from investment banking advice or custodial services. Combined with the trading revamp, the Morgan Stanley analysis suggests risk-weighted assets – the denominator in the capital ratio – at Goldman, State Street and Bank of New York Mellon could rise by almost 15%.

These are just two examples of what’s coming. In addition, regulators have much discretion. Big U.S. banks can expect a 20% increase in their required capital by 2027 when the rules kick in, Fed Chair Jay Powell told Congress last week. For U.S. institutions that regulators deem globally significant, that much extra padding would be around $180 billion, based on capital figures cited by PwC.

Such shifts have real-world consequences. More capital on the balance sheet means there’s less available to pay dividends and fund share buybacks. It can also make the business of banking more expensive. Bank investors typically demand a return on equity of around 10% – more than depositors or bondholders. More capital therefore implies higher earnings. That sways banks’ decisions on when to lend, and to whom.

The Basel tweaks have merit. For example, previous incarnations of the regulations didn’t effectively capture the risk of an unlikely event rattling a bank’s trading operations. But U.S. watchdogs had already added their own home-grown rules to fill some of the gaps. Fed stress tests subject banks to a theoretical market shock and incorporate elements of operational risk, and then spit out a “stress capital buffer” requirement tailored to each firm. That must be at least as large as Basel’s static “capital conservation buffer” of 2.5% of risk-weighted assets, and can be much bigger. Goldman’s is currently 6.3%.

The risk for banks is that new rules get piled on top of existing regulations in a process known as gold-plating. Fed Governor Michelle Bowman warned last week this can create competitive dislocations. However, the U.S. watchdog and its peers may see regulatory overkill as a feature, rather than a bug. Robust enforcement of rules is also one reason U.S. bank shares tend to trade at a premium to European peers.

Besides, regulators have been through a traumatic stress test of their own. The implosion of mid-sized lenders SVB Financial, Signature Bank and First Republic earlier this year left the Fed and Federal Deposit Insurance Corporation with egg on their faces. This helps explain why FDIC chief Martin Gruenberg said last week the new Basel rules may apply to all lenders with more than $100 billion of assets, dramatically widening the number of banks caught in the net. The regulatory burden will make midsized banks less competitive. It’s also not clear the additional rules would have saved SVB.

Another caveat is that regulations are only as good as the people who enforce them. Holding lashings of capital might give investors and some depositors greater comfort, but safety and soundness depends on bank examiners and monitors doing their jobs effectively. Recent bank failures showed that’s not happening. The Fed and FDIC are plagued by tech shortfalls, fractured reporting lines and stodgy processes that meant obvious problems at vulnerable banks failed to trigger timely action.

Step back, and it’s worth asking whether global harmony in banking rules is worth the considerable effort and paperwork. Sure, it’s helpful if cross-border rivals are required to calculate the riskiness of their assets in similar ways. But their safety depends on other factors, such as whether the central bank props up markets when things get tough, as the Fed does, or governments share losses when banks fail, as the Swiss government did recently with Credit Suisse. The fact is, though, that regulators tend to want more regulation. No wonder each test just brings more stress.

Context News

The biggest U.S. banks all passed annual stress tests administered by the Federal Reserve, the central bank said on June 28. In a simulation of a “severely adverse” scenario of global recession, the 23 lenders would have lost $541 billion, but all of their capital ratios would have nonetheless remained above the regulatory minimum. U.S. banks are awaiting a proposal from their regulators to revamp capital rules, expected in July. Part of the reforms agreed by the Basel Committee in December 2017, the new rules are often referred to as “Basel IV” or the “Basel endgame.” The rules would be unlikely to be finalized until mid-2024, Federal Deposit Insurance Corporation Chairman Martin Gruenberg said on June 22. Gruenberg said regulators were considering expanding the reach of a stricter set of capital rules to include banks with over $100 billion in assets. Federal Reserve Chair Jay Powell gave a similar message to Congress later that day, though he said the bulk of the capital reforms would apply to the biggest firms.

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