Keep on Yellen

Fed unease may yet shrink biggest US banks

The idea of shrinking the biggest U.S. banks may not be dead yet. The eight largest are adding billions of additional padding while also dealing with new rules on capital and liquidity. Federal Reserve boss Janet Yellen still isn't certain that's enough. Sure, it's the Fed's job to worry. But banking behemoths and their investors are already feeling the pinch.

In a speech on Tuesday, Yellen expressed concern that, despite aggressive efforts under the US Dodd-Frank reforms and international Basel III accords, large institutions remain susceptible to trouble. In particular, she pointed to their reliance on short-term funding from repo markets and other sources. Her fears echo commentaries from Fed Governor Daniel Tarullo. The policy options mostly point toward making financial firms hold additional stable, liquid capital.

The eight biggest US banks are already adding another $68 billion in capital thanks to regulators' new overall leverage limit, which forces US banks to maintain an unadjusted equity-to-asset ratio of no less than six per cent. The 30 largest lenders have already more than doubled their average ratio of Tier-I common equity to risk-weighted assets from 5.5 per cent in 2009 to 11.6 percent, according to the Fed's latest stress tests. The central bank is also working on a liquidity coverage ratio which is expected to make banks hold enough easy-to-sell assets to survive a 30-day stress period.

Short-term funding roundabouts such as repos merit scrutiny, partly because of the significant involvement of so-called shadow banks like hedge funds. But banking giants are already shackled far more tightly than before the 2008 crisis. The average Tier-I common equity ratio for banks with $10 billion or more in assets has reached 12.6 per cent, according to the Federal Deposit Insurance Corp, double the level in the early 1990s and the highest in the 23 years of record-keeping in this form.

The cost of a thicker capital buffer is showing in big banks' profitability. In the 1990s and early 2000s, the likes of JPMorgan, Bank of America and Citigroup typically hit returns on equity in the vicinity of 15 per cent. But the best of them, JPMorgan, is averaging just around 10 per cent since 2010. If Yellen's train of thought turns into action, it could make their task harder still. The lobby to break up huge lenders has lately lost momentum - but there's a point at which they or their investors will consider doing it themselves.