What does regulatory reform mean for banks?

What should investors make of changing US banking regulation? We believe a simplification of current rules would make sense, and could prove positive both for US banks and Treasury market liquidity.

After many years of tightening capital requirements and increased banking regulation, regulators in the US and Europe are beginning to pause and reflect. There is growing recognition that the current regulatory framework may have become overly complex and burdensome—potentially hindering banks’ ability to finance the economy.

US President Donald Trump was elected on a pro-growth, deregulation ticket, and the country is moving decisively on regulatory reform, potentially giving US banks a competitive edge. In Europe, policymakers are exploring ways to simplify rules and ease the regulatory load, with a view to maintaining a level playing field for their banks.

There is growing recognition that the current regulatory framework may have become overly complex and burdensome

Under the Trump administration, we have seen new appointments at many of the agencies that regulate banks – and that often play an important part in rulemaking. Initial regulatory changes have been proposed, and we think that the broader objective is a holistic review of the bank capital framework.

Following the Global Financial Crisis (GFC), capital requirements were tightened in both continents and many new rules were introduced, leading banks to hold much higher capital levels. These regulations were built piecemeal, leading to duplications and contradictions between different requirements and sometimes even led to unintended consequences.

For instance, the supplementary leverage ratio (SLR), which compares bank capital to on-balance sheet and some off-balance sheet assets, was introduced after the GFC. It was meant to act as a backstop to the risk-sensitive CET1 ratio, where a bank’s assets are weighted according to their risk, i.e. the riskier the asset, the more capital the bank has to hold. However, for some banks, it became the binding capital constraint, leading them to engage less in low-risk activities, such as Treasury market intermediation. On occasion, this has led to market dysfunction and spikes in US Treasury yields.

Under review: the SLR, capital requirements for large banks, and Fed stress tests

The Federal Reserve (Fed), has now proposed reducing the SLR for Globally Systemic Important Banks (GSIB). If such changes were to be enacted, we would expect Treasury market liquidity to improve. The GSIBs are all primary dealers, i.e. banks that are authorised to buy US Treasuries from the Fed and intermediate the Treasury market. This is a low-risk activity but one that impacts the balance sheet and thus the leverage ratio. By modifying the SLR, banks could hold greater inventories of Treasuries, notably in times of market stress, enabling them to fulfil investor purchases and sales.

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However, we would only expect such changes to result in a moderate increase in bank demand for such assets. Treasuries held for inventory are typically not long-term holdings and are likely to be quite volatile. In addition, banks already hold a substantial volume of Treasuries for liquidity purposes, and these holdings increased significantly following the 2014 introduction of the liquidity coverage ratio: from around USD 0.3 trillion in 2013 to around USD 1.7 trillion in 2024. As a result, we believe banks are generally unlikely to seek to hold many more Treasuries on their balance sheet as investments. This is especially true for longer-term Treasuries, which come with duration risk that banks may be unwilling to manage given their need to manage interest rate risk, as well as accounting impacts. Banks will also have an eye on the risks of too closely linking bank and sovereign risk, as seen in the euro area debt crisis from 2009 onwards.

Banks will also have an eye on the risks of too closely linking bank and sovereign risk, as seen in the euro area debt crisis from 2009 onwards

The additional capital surcharge for GSIB in the US is also being reviewed. This takes into consideration criteria such as size, complexity and interconnectedness. While for most banks, these surcharges are calculated using the Basel Committee’s assessment methodology, in the US, the Fed makes adjustments which result in a higher ‘Method 2’ score, which is used to calculate the capital requirement. For instance, under the Basel Committee’s assessment, JP Morgan currently has a 2.5% GSIB surcharge, which turns into 4.5% with Method 2. Given a lack of calibration for economic growth, GSIB buffers have been increasing and in some cases, are very significant. Adjusting this charge could free up more capital for banks to use.

The annual Fed stress test is also being reviewed. A lack of transparency over the process has sometimes led to surprising results and significant changes to a bank’s capital requirements from year to year. Thus US banks will tend to hold high capital buffers on top of their requirement just in case next year’s requirement goes up. Here we have seen some positive signs, with the 2025 stress test leading to lower capital requirements for the large US banks, and we expect further changes to the stress test process and increased transparency.

How would banks deploy freed-up capital?

A key question for investors is how the banks would deploy this capital. For now we think they will likely wait for more clarity on all aspects of the regulatory regime before making big changes. If such clarity is achieved and banks are left holding excess capital, they then face a choice on how to use it: for organic growth (e.g. more lending to corporates and households), dividends and share buybacks, or mergers and acquisitions (M&A).

We think US banks will likely wait for more clarity on all aspects of the regulatory regime before making big changes

We are already seeing some positive signals for investors on this front. Following the stress test, many US banks announced increased dividends. However, valuations are well above historical levels for some, potentially making share buybacks less attractive. Many banks also indicated that they would prioritise organic growth, pointing to many attractive areas for investment. Some also sounded more upbeat about M&A, although the bar appears to be set very high for most of them.

Investment conclusions

In conclusion, regulatory reform could lead to banks becoming more active in funding the economy, and perhaps regaining some of the market share they lost due to excessive regulation. Investors would likely welcome increased capital return from banks as a result of regulatory reform, while more organic growth should lead to higher earnings growth over time and hence be positive for share prices.

Investors would likely welcome increased capital return from banks, while more organic growth should lead to higher earnings growth over time and hence be positive for share prices

That said, both US and European banks have seen large share price gains so far this year, and much of the expected impact of regulatory reform looks already priced in. Interest rates are falling, while the US economy is cooling and Europe faces new tariff threats. While we favour cyclical sectors such as financials within our overall equity allocations, within this our most preferred sector remains communication services, given a robust growth outlook we believe is not yet fully priced in. Within the financial sector we prefer payment processing and financial exchanges, given their exposure to secular trends such as digitalisation.

Of course, there are concerns that too much deregulation could lay the foundation for the next banking crisis. It is hard to say whether that will be the case, but we note that the main purpose of the current deregulation wave is to simplify and recalibrate rules that have become too burdensome, not necessarily to lower capital levels significantly.