When the Federal Reserve and other bank regulators approved changes to the capital requirements for the nation’s largest banks last month it represented the culmination of a years-long campaign by the banking industry to push back on what they viewed as regulatory over-reach. Consumer groups argued otherwise. What’s interesting is not who’s on top at the moment,  but rather the implications that this has for the broader financial markets and particularly for public funds investors.

  • The revised capital requirements will lead to a modest reduction in the capital required by the largest banks. For creditors, and for the United States which practically speaking backs these too big to fail institutions, this is a small credit negative. The emphasis is on “small.” States and localities who are among the investors in debt obligations of these entities should not see any material deterioration in credit or credit rating. And, although it’s not widely discussed, the change could increase the likelihood of a government bailout of a large bank in a stress situation. Government intervention has generally meant that depositors and senior creditors are made whole.
  • The prime rationale for the changes—that they will encourage the banks to buy Treasuries and support the Treasury market—is clear evidence of the growing role of government debt in the financial markets. It used to be that the prime role for banks was seen as making business loans and underwriting home mortgages but now, in a sign of how much the financial system has changed, that has given way to supporting the issuance of government debt. The era of financial repression, much worried over by some economists, may have begun.

Dive Deeper

The changes to capital rules will reduce the capital requirements for the Global Systemically Important Banks. Companion actions will do the same for small (under $10 billion in assets) community banks. This takes place as financialization of the U.S. economy continues and  U.S. debt grows.

The Great Recession of 2008 was seen by some as a call to action around our over-dependence on financial markets, but the reality is that the dependence has increased in the past two decades. By one measure the economy now is even more dependent on the financial markets than it was 20 years ago, and large banks have grown even larger. Years of increased regulation have not changed this trajectory despite an explosion of requirements that, critics argue, have led to regulators micromanaging banks.

The accompanying chart documents the growing role of banks. In 2005 commercial bank assets totaled 64% of gross domestic product; they have risen to 79% (at the end of the first quarter of this year). Assets of the largest bank, JP Morgan, now represent 18% (!) of total bank assets, up from 13% 20 years ago, and the top banks represent 40%.

So banks are a bigger part of our (business) lives than in the past and big banks command a larger share of the industry.

Banks also are looked on to fill a different role in our economy. Business lending and the residential mortgage market, once center stage, are no longer. In their place are funding the growing debt of the U.S. government and maintaining stability in a market that is dominated by Treasuries.

And no wonder, since outstanding Treasury debt has quadrupled in amount in 20 years to $38 trillion today. It’s become the major focus of the financial markets. In a manner of speaking, it’s as if we’d slid into an era of financial repression, where servicing our debt crowds out other activities, without realizing it.

Banks have hardly shirked the market in this regard.  As the accompanying chart illustrates they currently own about  12% of all Treasuries.  Their holdings have grown over the period but the explosion of debt beginning with the pandemic has simply outpaced.  But if banks do more in the Treasury market where will they do less? 

What This Means for Public Agencies

The lower capital requirements are expected to boost bank demand for Treasuries. If you hold Treasuries, and public agencies collectively own more than $2 trillion, that’s a good thing because it will support prices and liquidity. (There is a counterview that weak demand is good for buyers because it pushes prices down, and yields up, but this “vulture view” is far out of the mainstream.)

Other recent steps by the Fed will also result in more support for the Treasury market. These include a change in its portfolio strategy that will replace maturing mortgage-backed holdings with Treasures and a plan to purchase $40 billion of Treasury bills   this month  and for at least the next several succeeding months to stabilize the markets over year-end and into 2026.

Proponents of the new capital rules say they will improve overall bank stability. This is true, but perhaps with an odd turn, because when (!) the next bank run occurs the largest banks will be more able to accept deposit inflows without breaching their capital requirements. This might actually encourage a flight to big when the market comes under stress.

The new capital rules will also support liquidity in the repurchase agreement market. States, other large public units, and local government investment trusts are the main public sector players in this market   Even at its current size, estimated at $12 trillion (including both repo and reverse repo trades), it’s a whale. It has been characterized by volatility from time to time, particularly at month-end and quarter-end as the main players, the GSIBs and other larger broker dealers, pull back to window dress their balance sheets. The pressure to do this will lessen with the new capital rules and public agency players should have an easier time maintaining repo balances.

Bank Credit Will be Weaker Under the New Rules

For creditors (those who hold commercial paper, have deposits, hold financial company bonds and notes) more capital is better so this is a credit-negative event. By itself it is not a big credit negative because, as we learned with the failure of Silicon Valley Bank, market interconnectedness means that  even a mid-side bank—SVB had slightly more than $200 billion when it failed—is likely to be bailed out by the government.

But in a perverse way, continued growth of the G-SIBs and other large banks to support the Treasury markets will make “too big to fail” support even more essential. This may not be good for the political/economic system, but it likely means depositors in the very largest institutions will be protected from financial catastrophe.

So if there is increased risk it lies with the smaller bank universe where a problem is unlikely to bring government support beyond that available through deposit insurance.

The community banks confront this headwind daily. Why bank locally when Uncle Sam effectively backs the big guys?

Bank policy and regulations have not effectively answered this question.