As highlighted in this week’s Treasury Department Developments (see below), we are seeing a continued focus on capital reserve levels at banks that are considered by regulators to be systemically important. The new report from the Treasury Department comes after the Federal Reserve Board (“Fed”) is already well under way in formulating capital adequacy rules that are unique to large banks.

As discussed in our December 15, 2014, Financial Services Update (which can be found here), the Fed published a proposed rule that would impose additional capital reserve requirements (often referred to as “surcharges”) upon a subset of large banks that the Fed determines to be systemically important. The surcharges would be phased in starting in 2016, with full implementation by 2019. As reported in the press and acknowledged by Fed Governor Daniel Tarullo, the proposed surcharge is in excess of requirements developed by the Basel Committee.

Higher reserve requirements result in banks being unable to put as much of their balance sheet to work as might be desired from a market competitiveness perspective. Banks also must become more reactionary as the reserve requirements increase, making long term strategic planning more difficult to formulate and achieve because assets that might normally make sense to retain at a given point in time must be liquidated in order to maintain the required capitalization ratio. The positive effect that the regulators hope will be the trade­off for this hamstringing is a larger asset­base on which to fall back in the case of a large­scale market disruption.

Recent currency fluctuations reveal that the surcharge amplifies negative effects of market trends in a way that is particularly harmful to the subset of banks that are subject to the surcharge. This week, The Wall Street Journal reported (here) on a concern that the increasing strength of the U.S. Dollar relative to other major currencies such as the Euro would have this negative amplifying effect if the proposed rules were to be implemented. In the six months from June 30, 2014 to December 31, 2014, The Wall Street Journal’ss Dollar index measured a change from 72.60 to 83.02 (a ~12.5% increase over six months). The strength of the Dollar has continued to

increase since the beginning of the year. Banks that would be subject to the surcharge would, in a situation such as this, be even more disproportionately disadvantaged vs. non­U.S. banks than if they followed the same capital adequacy rules as banks that are not subject to the surcharge. The result of this fast currency fluctuation is that, in a relatively short period of time, a few relatively healthy U.S. banks might be forced to hold a higher percentage of their assets in the form of cash in reserves than, say, some much less healthy European banks; a result that seems unfair from a competitiveness standpoint and counterintuitive from a systemic stability standpoint.

Consider, also, the effect of sharp fluctuations in particular industries on loan portfolios. Oil and gas prices came down sharply in the second half of 2014. The Bank for International Settlements reports (here) that the price of crude oil dropped in that period by roughly 50%. Natural gas also took a tumble (see here). This week’s news included expectations for further ratings downgrades of oil and gas producers (here). Under the proposed Fed rules, banks that are subject to the surcharge and that have relatively heavy portions of their portfolio in oil and natural gas might have to quickly increase their cash reserves (or sell their oil and gas loan assets) in order to counterbalance their increased risk profile. These changes may not be required by banks that are not subject to the surcharge (or may not be as extensive). In the medium and long term, lower energy prices are a boon to the economy as a whole and are likely to increase the strength of the rest of the bank’ss portfolio – just not right away. The result may be that banks subject to the surcharge might have to make reactionary decisions based on short term market fluctuations rather than stable long term strategies in a way that banks not subject to the surcharge (some of which may not be as financially healthy) may not, which, as in the case of the currency fluctuations, seems unfair from a competitiveness standpoint and counterintuitive from a systemic stability standpoint.

Comments on the proposed rules are due by February 28 (though the Fed’s website now lists March 2, because February 28 is a Saturday). See here for the proposed rule and to submit comments.