Credit Musings: September 21, 2023

Sep 21, 2023


Public Trust Credit Team

Potential U.S. government shutdown and its uncertain impact on credit markets

A potential government shutdown is looming over the U.S. as Congress approaches a September 30 deadline to agree on spending legislation and pass a federal budget. A government shutdown would result in the suspension of non-essential government operations and the furloughing of associated federal employees. It is worth noting that during a government shutdown, the U.S. Treasury continues to issue bonds and make repayments. However, the ultimate impact that a potential shutdown could have on credit markets remains uncertain.  

The uncertainty stems in part from the unknown duration of a potential shutdown. The U.S. has experienced three shutdowns over the last decade: December 2018 (34 days), January 2018 (3 days), and October 2013 (16 days). During a shutdown, the agencies that publish economic data – including unemployment and CPI datapoints – are shut down as well, leaving the market without many key indicators for as long as a shutdown persists. Second-order impacts of a shutdown could include an erosion of public confidence in the U.S. government and the economy and uncertainty as to how a shutdown would be viewed by the credit rating agencies that maintain a sovereign credit rating on the U.S. 

The possibility still exists that a government shutdown can be avoided, but if one should occur, market participants will need to remain vigilant in monitoring the ongoing situation for any factors that could result in a material change in credit or other market conditions. 

What the new Basel III Endgame proposal would mean for U.S. banks.

The Public Trust Credit Team attended the Barclays Global Financials Conference in New York City last week where the main topic of discussion for U.S. banks was dominated by the Basel III Endgame proposal that was released in July 2023. Now that banks have had time to digest the proposal, we would like to offer pertinent insight as to how the proposal would affect U.S. banks. 

Capital: The most prominent change would be the way risk-weighted assets (RWAs) are calculated moving forward. The proposal would adjust the current risk weights and raise the weighting materially for market-related instruments. In addition, there would be a new operational risk component that would increase RWAs and primarily affect the largest banks. Banks with more traditional lending exposure would likely see the lowest increases (0%-5%) while banks with complex business lines and material market exposure would likely see much higher increases (15%-20%). Why is this important? Capital requirements are not changing; but because RWAs are the denominator of the CET1 calculation, most banks would likely need to build capital to remain at their current buffers. The proposal would also disallow certain internal models for risk calculation which would, ideally, make capital and RWA’s more easily comparable across banks. Fortunately, U.S. banks will have until 2028 to build – if the proposal passes in its current form.  

Regional Banks: Under the proposal, Category III & IV banks ($100+ billion in assets) would be required to include accumulated other comprehensive income (AOCI) in their regulatory capital calculation. What this means is that the mid-to-large size regional banks would have to include unrealized losses on fixed-income securities in their capital calculation – which is how the largest banks currently report. For investors, this is likely beneficial as it adds more transparency to regulatory capital – and was an expected change after all the regional banking stress in March. For the banks, the change is positive in a declining-rate-environment and negative in a rising-rate-environment. However, although regional banks currently have a large balance of unrealized losses, the phase-in will not be complete until 2028 and we expect most of these losses will be pulled to par by then, making the likely final impact on capital minimal.  

Bank CEOs have come out as broadly negative on the changes and we will move into the public comment period soon, which may lead to revisions to the final version of the rules. However, it appears likely that U.S. banks will need to build some capital moving forward and the regional banks are likely to see more stringent rules than the ones they have enjoyed the last five years.  

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses. 

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