(Bloomberg) -- A proposal by top US banking regulators to boost the minimum denomination of long-term bonds issued by lenders under new debt requirements would create impediments for smaller investors and increase costs for regional banks, a trade group representing investment managers said. 

The Federal Deposit Insurance Corp. and the Federal Reserve in August unveiled proposals to increase oversight of midsize lenders in response to the bank turmoil that roiled the industry earlier this year. As part of the proposed rules, banks with as little as $100 billion in assets would be required to issue enough long-term debt to absorb capital losses in times of severe stress, compared with the current $250 billion cutoff.

Regulators have indicated they want this new long-term debt to be held by sophisticated institutional investors who would be better able to stomach losses in the event of a bank failure, as opposed to individual investors. One way they hope to limit retail participation is by raising the minimum bond denomination requirements on this debt to $400,000 from the current industry standard of $2,000. But the higher threshold would also create problems for investors managing smaller mutual funds and exchange-traded funds, according to the Credit Roundtable. 

These smaller investors, with less under management, would be forced to take an overweight position on a single issuer when buying new bonds, the group said in a Nov. 8 comment letter to the FDIC. That would mean “material consequences” for investors looking to diversify their small portfolios, an increase in client tracking error to their benchmarks and even push some investors to shift their allocation to the largest banks.

“We believe this is at odds with regulators’ general intent to limit ‘Too Big to Fail’ and the desire to have an economically viable regional banking landscape to serve the needs of U.S. small and medium-sized businesses,” the group wrote in the letter. 

Distortions Seen

The higher denominations might also make the market less liquid and concentrate the bonds into a small number of investors and mutual funds, said the group. Larger minimum denominations would also make it impossible to add or reduce exposure to a position on a pro rata basis, they added.

“The proposed minimum denominations rule is going to materially distort the investible universe,” David Knutson, chair of the Credit Roundtable, said in an interview. “It’s also going to seriously impact the cost of financing, the availability of credit and the profitability of the US banking system in general and relative to other banking systems.”

Financial companies are the single-biggest issuers of US corporate investment-grade bonds. The cohort has borrowed over $480 billion in new bonds this year through Nov. 7, according to Bloomberg News analysis. That represents roughly 44% of total high grade volume this year.

The Credit Roundtable also noted that certain preferred securities issues by banks — ranked below senior unsecured long-term debt  — can be bought by institutions in increments of $1,000, while retail buyers can scoop them up in $25 denominations. The group is struggling to understand why senior unsecured notes “would be viewed as inappropriate” for retail investors while common and preferred equity are allowed in smaller denominations.

“We also note that non-US banks issue senior unsecured debt in USD at much lower denominations than what is being proposed for US banks,” wrote the group.

©2023 Bloomberg L.P.