Personal Loan Approval Could Shrink in the Future. Here's Why

Banks could soon face greater capital requirements if new rules being prepared by U.S. regulators take effect. In a nutshell, these rules would increase bank capital requirements to as much as 20%. And the actual proposal could come any day now.

According to a Reuters report, the proposal would take effect at the beginning of 2025, and according to the Federal Reserve's vice chair for supervision Michael Barr, the Fed is expected to reveal the full details of its plan later this summer.

This comes on the heels of several high-profile bank failures in the United States this year, and Barr specifically said that the Fed was "carefully considering" rule changes for the larger regional banks. The largest banks would be expected to see the largest capital increases under the new rules, but many U.S. financial institutions could be affected.

Why it matters for personal loan borrowers

The idea behind the rule changes certainly makes sense. Banks that are better capitalized are well-positioned to handle major writedowns of their assets without defaulting on creditors or (more importantly) losing depositors' money.

However, the effect is that the more capital a bank must keep, the less money it has available to lend. And when a bank is faced with less money to lend, its credit standards tend to get higher. A bank could stop lending to all but the highest-credit borrowers, or could end certain forms of lending altogether.

For example, banks have historically paused home equity lines of credit (HELOCs) during uncertain times, and are known to start canceling unused credit cards for borrowers they perceive as a relatively high risk. And it's logical that personal loans, which are relatively high-balance, unsecured debts, could be on the chopping block as well.

To be sure, personal lending isn't likely to be scrapped entirely if capital requirements rise. But it's fair to expect banks to reduce the volume of personal loans they are willing to approve, and this could make it far more difficult to obtain a personal loan with less-than-stellar credit.

Adding fuel to the fire

It's also important to note that several personal lenders have already started to pump the brakes on personal loan approvals. And it has nothing to do with capital requirements.

There are two big reasons banks decide to loan less money. The first is because they don't have the money to lend, and higher capital requirements are one form of this. The second is because they don't want to lose too much money when borrowers can't repay their debts, or banks think this might happen in the future, and this is what we've already started seeing.

Specifically, we've seen interest rates increase significantly over the past year and a half or so, and many experts are calling for a recession in the near future. Recessions are generally accompanied by rising unemployment, which also generally leads to a rise in loan delinquencies. So, many banks have already started increasing their credit standards or reducing loan volume. In fact, U.S. domestic banks reported a significant tightening of lending standards during the first quarter of 2023, before the regional bank failures.

The bottom line

For borrowers, the key takeaway is that lending standards have already tightened in the United States in response to economic uncertainty. And they could tighten even more if new banking regulations increase capital requirements.

However, borrowers with excellent credit are likely to be the least affected. And since the proposed capital requirements won't go into effect until 2025 at the soonest, it could be more important than ever to take a closer look at your credit score and make a plan to boost it.