In a significant move, the Federal Reserve has released the first part of its multi-phase plan to deregulate banks, with a formal proposal announced on March 19th. The proposal aims to ease capital requirements for banks, particularly the largest globally systemically important banks (GSIBs) such as Chase and Bank of America, as well as regional and community banks. In this blog post, we’ll break down the key components of the proposal, its potential impact on the economy, and what it means for investors.
The Federal Reserve’s proposal has three main components. Firstly, it simplifies capital calculations for the largest banks by using a single, more risk-sensitive approach instead of dual calculations. This change is expected to reduce capital requirements, allowing these banks to increase their lending capacity. Additionally, the proposal averages risk calculations over the entire year to prevent “window dressing” at quarter-end.
Secondly, the proposal adjusts capital requirements for all banks except GSIBs, making mortgage lending easier by reducing disincentives. It also requires banks to report unrealized gains and losses on certain securities for greater transparency.
Thirdly, it refines the measurement of systemic risk for large and complex banks, leading to slightly less restrictive capital regimes for community and regional banks. This is expected to encourage more lending to small and medium businesses.
While the proposal is a step in the right direction, it’s not a done deal yet. The supplementary leverage ratio (SLR), a separate regulation that currently restricts banks’ ability to buy treasuries and impacts long-term interest rates, remains unchanged. Until the SLR is addressed – either reduced or removed – the full benefits of deregulation in terms of credit expansion and lower interest rates are unlikely to be realized.
The proposal is expected to have modest, gradual effects on lending and the economy over several years. The high existing interest rates are currently suppressing demand for mortgages and other loans, limiting the short-term impact of the deregulation.
Banks might channel the increased capacity enabled by deregulation into share buybacks and dividends rather than significantly expanding lending. This could potentially exacerbate economic inequality and reinforce the existing K-shaped recovery. However, risk-taking by banks is unlikely to spike dramatically because the new rules enhance transparency and control over risk.
For investors, financial sector ETFs like XLF (broad financials), KBE (banks only), and KRE (regional banks) might be potential avenues to benefit, especially regional banks which could see relative advantage. However, much of the deregulation optimism is already priced into the market, and any trades on this theme should be considered long-term (1-2 years). Strategies like LEAPS options combined with call selling (diagonal spreads) could be used for risk management.
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The Federal Reserve’s bank deregulation plan is a significant step towards simplifying capital requirements and reducing regulatory burdens. While the proposal has its limitations, it has the potential to increase lending capacity, encourage more lending to small and medium businesses, and benefit investors in the financial sector. As with any investment opportunity, it’s essential to do your research, consider the long-term implications, and manage your risk. For further insights and information, watch the full YouTube video from Heresy Financial.
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