Get Ready for Bank Deregulation

SUMMARY

Joe Brown, a former stock broker and financial educator, discusses the likely removal of key banking regulations and its potential impact on lending, government debt, and inflation. The analysis covers the supplementary leverage ratio, liquidity coverage ratio, and the broader economic implications of deregulation for both public and private sectors.

MAIN POINTS

• Introduction of the supplementary leverage ratio (SLR) and its role in limiting bank lending post-financial crisis. [1:00]
• Explanation of the liquidity coverage ratio (LCR) and how it requires banks to hold high-quality liquid assets. [4:00]
• Review of the 2020 temporary suspension of the SLR, which allowed banks to increase lending and purchase more treasuries. [7:01]
• Discussion of current government debt challenges and the rationale for considering deregulation to facilitate more treasury purchases by banks. [9:00]
• Analysis of how removing the SLR could boost both government and private sector lending, potentially lowering interest rates and increasing economic growth. [11:01]
• Projection that bank deregulation is likely imminent, with expected effects on treasury yields, private lending, and inflation offset by productivity gains. [14:01]

DETAILED ANALYSIS

Bank deregulation is poised to return to the forefront of U.S. monetary policy, with significant implications for financial markets and the broader economy. The supplementary leverage ratio (SLR), introduced in 2014 following the financial crisis, requires banks to maintain a minimum level of tier 1 capital relative to their total leverage. This rule was designed to prevent banks from overextending themselves with risky or excessive lending, regardless of the risk profile of the underlying assets.

For globally systemically important banks, the SLR is set at 5%, while other large banks are held to a 3% threshold. This regulation, however, does not differentiate between risk-free assets such as U.S. treasuries and riskier private loans, imposing a uniform cap on all lending activities.

Alongside the SLR, the liquidity coverage ratio (LCR) mandates that banks hold a sufficient reserve of high-quality liquid assets (HQLA), primarily U.S. treasuries, to withstand a 30-day period of significant liquidity stress. While these regulations are intended to safeguard the financial system, they can work at cross purposes. The SLR limits total lending, including the purchase of government debt, while the LCR compels banks to hold more treasuries, creating a regulatory bind that restricts banks' ability to support both government borrowing and private sector lending.

In response to the extraordinary fiscal measures during the COVID-19 pandemic, the Federal Reserve temporarily suspended the SLR in April 2020. This allowed banks to expand their balance sheets, purchase more treasuries, and increase lending to households and businesses. The result was a surge in bank lending and a significant reduction in treasury yields.

However, the suspension expired in 2021, forcing banks to adjust by shedding deposits and reducing lending, which contributed to the expansion of the Federal Reserve's reverse repo facility. Subsequent monetary tightening and balance sheet reductions have since normalized these conditions.

The current fiscal environment is marked by a national debt exceeding $38 trillion and persistent annual deficits projected to rise further. Traditionally, such fiscal pressures would be alleviated by central bank interventions like quantitative easing. However, recent commentary from influential figures such as Scott Bessant, Kevin Walsh, and Fed Governor Steven Moran suggests that deregulating banks by removing the SLR is now being considered as an alternative solution.

This move would enable banks to purchase unlimited amounts of treasuries, effectively acting as a decentralized form of quantitative easing and potentially lowering government borrowing costs by reducing yields across the curve.

Eliminating the SLR would also free banks to increase lending to the private sector, as their balance sheets would no longer be constrained by the cap. This could allow households and businesses to refinance debt at lower rates, stimulate new borrowing for productive investments, and foster economic growth. While the expansion of lending would increase the money supply and carry inflationary risks, these could be partially offset by gains in productivity and economic output.

The analogy of a growing pizza illustrates this dynamic: as more money (slices) enters the economy, simultaneous growth in real output (pizza size) can prevent runaway inflation.

Ultimately, the anticipated deregulation is expected to be coordinated between the Federal Reserve and the Treasury, with the goal of supporting both government financing needs and private sector growth. While this strategy could provide temporary relief from high interest costs and stimulate economic activity, it is constrained by real-world factors such as the availability of energy, materials, and other inputs. The balance between financial engineering and physical economic limits will determine the long-term effectiveness and consequences of this policy shift.

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