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An Update on Bank Regulations: The Dead Parrot Sketch*

January 15, 2025
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If there were any doubt, the resignation last week of Michael Barr as vice chair for supervision of the Federal Reserve signals that the effort to tighten capital and supervision rules for banks is dead.  Barr was the point person in this effort, and in post-election comments he and Federal Reserve chair Jerome Powell had indicated they would resist pressure from the incoming Trump administration to remove Barr.  In his resignation letter Barr said he was moved to this action by “the risk of a dispute over the position.” He will remain a governor of the Federal Reserve for a term that runs until 2032.

The proposed rules would set new capital standards for banks and alter the way they are supervised, all in response to the Basel III endgame first announced by the Basel Committee on Banking Supervision in 2010 and designed to improve global financial stability after the 2008-09 financial crisis.  The banking industry has argued that the rules proposed for U.S. institutions would increase the cost of banking and discourage banks from making some loans, thus handicapping the economy.  Bu regulators claimed they would reduce the risk of a ban-caused financial crisis such as the 2023 events that transpired when Silicon Valley Bank went under.  Caught in the middle are customers, including states and local governments, who rely on banks for vital services, and taxpayers, who inevitably pay the bill for economic/financial disruption.

Banks are not crowing about the likely pullback of rules—at least not publicly.  Rather they are promoting the notion that this would be an opportunity to tailor any new rules.   But the theme of “unleashing” capitalism likely will lead to the proposed rules being withdrawn in favor of a study and analysis interregnum that could take several years.

Why it matters.  Banks play an essential role in the public funds investment world, as service providers (think custody, investment management, brokerage and trading) and investment counterparties—they are dominant issuers of credit-based money market securities (commercial paper and negotiable certificates of deposit) and high-grade corporate bonds.  The banks argue that the proposed capital standards would require more capital for bank services, thus forcing banks to raise prices or exit some business lines.  But a stronger capital base could also shore up the credit of investment counterparties.  In a few words, public units could pay more for banking/investment services but their deposits/investments in banks could be more secure (and the risk of a financial crisis would be lessened).  This is a cost/benefit analysis where those who pay the cost are different than those who gain the benefit and that is a prescription for disagreement.

To complicate things further there is an element of large bank vs. community bank in all of this.  The very largest banks (the 8 US global systemically important banks and 21 non-US G-SIBs) and larger regional banks operate in their own world.  Supervision and capital requirements may be a burden, but these institutions also have resources not available to smaller banks. There are levels of regulations tiered to bank size, but this has the indirect effect of disadvantaging smaller banks. For example, a large bank may be required to have more capital, but it has access to the public debt financial markets to raise debt and this may help it maintain a better credit profile.  A bank may be viewed as too large to fail and investors could prefer the bank on the (not unrealistic) belief that the Federal government would prop it up, supporting its depositors, in times of stress.  All of this disadvantages smaller banks.

There seems to be a “rip away the regulations and leave us be” mood in America these days and when it comes to banks, a case to be made that things are fine as is. (Yes, there were the 2023 bank failures, but bank advocates argue that this was because regulators failed to supervise.)   Yet it’s clear that banking is an industry where a few bad apples can ruin the basket.  The 2023 bank failures did not involve community banks, but community banks as a group suffered a run as depositors pulled funds in favor of government money market funds and too big to fail banks.

The banks also argue that they are well-capitalized, which has improved the risk profile of banks who issue money market instruments and bonds.  This is true: capital levels are up, and bank credit ratings have generally improved over the past several years.  But a cynic might observe that some of the capital build has been in anticipation of the Basel III recommendation and proposed new capital requirements, which are not going forward.  Without final regulations many of the banks will likely return capital to shareholders. 

Bank shareholders like the recent turn of events.  An index of money center bank stocks is up nearly seven percent since November 1, while an index of smaller regional bank stocks is up 4%.   (The S&P is up 2% at this writing.)  That is not surprising.  Investors in bonds are not so favorable.  The spread they require to invest in issues of financials instead of government bonds has widened somewhat since mid-December.  It’s not a monumental rise, but it can be taken as a signal of (modest) concern.

Other forces at work. While the banking sector is now largely free from the disruption related to new capital rules, we’ll be watching other things that could disrupt the industry.  Some members of Congress have called for abolishing the Federal Deposit Insurance Corporation and turning its insurance responsibilities over to the Treasury Department.  This would require an act of Congress and would open the broader deposit insurance and regulatory framework to change.  With nearly $800 billion in bank deposits state and local governments have a vital interest in this.

For another, private credit is knocking on the door, seeking entry into markets hitherto dominated by banks.  Some of these lightly regulated firms already provide trading and “fintech” services to state and local governments.  They also may issue securities to finance their activities.  They may appear to be banks, but they are not, and their business models and the factors that shape their credit differ from those of banks.  As their prominence grows public sector investors will have to consider whether and how to do business with them.

*From Monty Python’s Flying Circus.


Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

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Marty Margolis

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