As banks face Omicron risk, their size could become a handicap

Big lenders were among the hardest-hit stocks in the market’s intense reaction to the Omicron variant last week, with S&P 500 banks dropping nearly 4% on Friday, much more than the overall index. In some respects, this doesn’t track: Things that hurt bank stocks as the pandemic and lockdowns gathered momentum last year included the suspension of buybacks, a plunge in rates and a surge of credit concern.

Today, rates are already superlow, credit losses have been more than manageable and buybacks have resumed. Big-bank stocks are up over 30% this year. So investors might well see any near-term weakness in banks as a buying opportunity. Yet there are some other factors to consider.

A major one is banks’ size, which can affect their capital requirements, which in turn drives how much cash is available for buybacks or higher dividends. Banks are still fairly loaded up with government bonds and with cash from deposits, causing their balance sheets and thus their capital requirements to swell. So they have relatively less flexibility to absorb another round of inflows or set-asides for possible loan losses and emerge with the same degree of excess capital.

Then there is the question of how the changing composition of the Federal Reserve under President Biden—especially when it comes to bank supervision—affects measures that would give banks more flexibility, such as a long-term exclusion of reserves from leverage measures.

Some of the largest lenders have also long hoped for adjustment to the extra capital requirement imposed on global systemically important banks, considered the key firms for financial stability. Based partly on banks’ size, these requirements have been trending higher through the pandemic and into this year. At third-quarter levels of assets and other variables, banks such as Bank of America, Goldman Sachs, JPMorgan Chase and Wells Fargo could be in line to need higher buffers, according to calculations by analysts at Credit Suisse.

Keep in mind that these levels aren’t completed until year-end, and even then only turn into higher minimums after a couple more years. So banks in theory have time to shrink back down, which often happens.

But there has also long been the prospect of a recalibration of these measures to adjust for economic conditions driving the banks to be bigger. That task would likely fall to the next head of bank supervision—and a Democratic appointee may be less inclined to make a favorable adjustment.

None of this is a threat to banks’ overall health or stability. But that isn’t necessarily what matters for stock prices. Investors right now are quite attuned to capital returns and the capacity to add higher-yielding assets over time.

Analysts at Goldman Sachs estimated in November that while seven of the largest U.S. banks had excess capital representing about 8% of their market value, existing capital-return plans could deplete that surplus over the next three years, even with solid earnings, should there be rising capital minimums and risk-weightings for certain assets.

There are some potential boosts to bank earnings. A degree of economic uncertainty could actually drive more borrowing, if people and companies drew down on lines of credit. Market volatility can also deliver big revenue for capital markets and trading desks. Long-term, rising rates portend much stronger earnings, too. But with all things Covid-19, investors shouldn’t necessarily expect the past to be a reliable guide for the future.