Testing the Mettle of Too-Big Banks

Goldman Sachs’s decision to sell its metal-warehouse business is a reminder to investors just how much sway regulators have over the biggest banks through their power to set capital requirements.

Investors in the biggest banks in the U.S. are no strangers to the power of capital regulation, of course. The annual “stress test” process has made it abundantly clear that regulators control not only how much capital can be returned to shareholders but whether the return takes the form of buybacks or dividends. At most, banks get to choose the timing of those returns.

But capital regulation does more than determine dividend and buyback levels. It also determines the basic cost of doing business for the biggest banks—and influences just what sort of business they will do.

Goldman, which picked up metal-warehouse operator Metro International Trade Services just four years ago, decided to sell the business after regulators in the U.S. began to mull a capital surcharge on the physical-commodities businesses of big banks. Capital charges also likely played a role in J.P. Morgan Chase’s move to sell its physical-commodities and warehousing business.

That is because rules directing banks to fund their physical commodities businesses with a greater level of capital raise the required return hurdle for those businesses. Given a sufficiently high capital charge, regulators can make any business unattractive. Just as Chief Justice John Marshall once said that the power to tax is the power to destroy, the power to apply capital surcharges is the power to trigger divestment.

This isn’t necessarily bad news for investors. Keep in mind that capital surcharges are meant to match up with the risk of the assets to which they apply. If a business is capital intensive, it is because regulators think it is particularly risky. To the extent that regulators get it right—far from a sure thing—they are doing investors a favor by revealing which areas might be too risky for the amount of revenue they generate.

If regulators get things wrong, though, investors can suffer. Risks can build undetected and banks can be pushed away from businesses with good risk-adjusted returns.

For investors, the lesson is relatively simple. Capital regulation now squeezes at both ends of the business of the biggest banks—from the generation of revenue to the return of capital. And the costs of being too big to fail will keep mounting.

via HEARD ON THE STREET: Testing the Mettle of Too-Big Banks – WSJ Article by John Carney

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