US Banking | Fed Rethinks Loophole That Masked Losses on SVB's Securities

Led by vice chair for supervision Michael Barr, the Fed is considering ending an exemption that allows some banks to boost the amount of capital they report for regulatory purposes, according to people familiar with the matter. Capital is the buffer banks are required to hold to absorb potential losses.

Regulators are weighing the change after the sudden collapses last month of SVB and Signature Bank rattled the financial system. If adopted, it would reverse a loosening of rules by the Fed in 2019 and heighten oversight of midsize banks by extending restrictions that currently only apply to the largest, most complex firms.

All told, regulators are considering extending toughened restrictions to about 30 companies with between $100 billion and $700 billion in assets, the people said. A proposal could come as soon as this summer, and any changes would be phased in, potentially over a couple of years.

Regional banks such as U.S. Bancorp, PNC Financial Services Group Inc., Truist Financial Corp. and Capital One Financial Corp. could be affected, and could be made to bolster capital. That could prompt steps such as trimming buybacks, retaining more earnings or raising new capital from investors. Banks are planning to fight rule changes.

Mr. Barr has hinted at a series of tougher rules to come after SVB's failure, changes he said would boost the resilience of the financial system. For example, he noted SVB's capital levels didn't have to reflect unrealized losses on certain securities.

“We are evaluating whether application of more stringent standards would have prompted the bank to better manage the risks that led to its failure," he told lawmakers.

The potential change he mentioned relates to how banks in regulatory capital measures reflect unrealized gains and losses for securities labeled “available for sale." Banks have the option of selling such securities or holding them to maturity.

Under post-financial crisis rules, banks with more than $250 billion in assets were directed to include unrealized gains and losses on such securities in their capital ratios. Smaller regional banks, however, were allowed to skip this requirement based on the argument that it would introduce too much volatility into their capital metrics. In 2019, the largest U.S. regional banks earned an exemption, too.

The changes under consideration would likely reverse that reprieve, meaning unrealized losses would dent capital levels.

“Available for sale" securities played a role in the downfall of SVB, which had availed itself of the exemption. In March, SVB announced that it had sold a chunk of securities at a nearly $2 billion loss and said it would sell stock to raise capital.

That raised fears of dilution for existing shareholders and highlighted for investors the risk of unrealized losses on SVB's books. SVB shares plunged, and customers pulled $42 billion in deposits the following day, prompting regulators to seize the bank.

SVB was sitting on even bigger unrealized losses in a separate bucket of securities that the bank said it would hold to maturity. Those losses aren't recognized either in the bank's financial statements or in regulatory capital.

The changes currently under consideration by the Fed wouldn't apply to the treatment of losses for those securities, but may be addressed later.

Supporters of a change to capital rules for unrealized losses on banks' “available for sale" securities say this would have forced SVB to address the issue far earlier as interest rates began rising and the value of its holdings declined.

Banks, however, say the change could lead to higher government borrowing costs and mortgage rates. They say having to hold more capital, coupled potentially with limitations around securities they plan to hold to maturity, could instead prompt lenders to pull back from buying long-term Treasury debt and mortgage-backed securities.

Rising interest rates have left many banks sitting on big unrealized losses, meaning the prospective rule change would hit their capital ratios harder than it would have in the low-rate world. For instance, a key balance sheet metric that includes unrealized losses on “available for sale" securities at Pittsburgh-based PNC Financial Services Group Inc. was negative $9.1 billion at the end of the first quarter, compared with negative $5.7 billion a year earlier.

Tougher rules were already on the way for the biggest banks, as the Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency moved toward imposing new regulations crafted by regulators around the world after the 2007-2009 financial crisis.

The latest step in that overhaul is expected to be proposed in June, in conjunction with a proposal to close or narrow the “available for sale" exemption.

“One way of making banks safer for the whole economy is to ensure a larger capital buffer," said David Kass, a finance professor at the University of Maryland's Robert H. Smith School of Business.

Even without any rule change, U.S. Bank has said it expects to be subject to more stringent rules soon. The Minneapolis-based firm is growing and is likely to cross an existing threshold for lenders with more than $700 billion in assets. Executives on Wednesday said on an earnings call with analysts that change would happen “no earlier than the end of 2024."

Chief executive Andy Cecere said he didn't think the bank would have to raise capital to boost its ratios but could instead rely on higher earnings and other measures. He called increasing the capital ratios “priority one."

HoldCo Asset Management, an investment firm with a short position in U.S. Bank stock, on Monday released a presentation raising concerns about the lender's capital levels. Using data from the bank's fourth-quarter earnings, the firm estimated a key capital ratio would fall to 6.1% from 8.4% if it had to account for its securities losses.

Write to Andrew Ackerman at andrew.ackerman@wsj.com and Rachel Louise Ensign at Rachel.Ensign@wsj.com