Financial markets already preparing for Trump deregulation

[Neu Leonstein]

This was an interesting article from a couple of days ago: Treasury's Regulation Unwind Already Having An Effect on Markets

The Treasury’s proposal to unleash financial sector animal spirits constrained over the last seven years by the weight of regulations is already sweeping through markets.

Just look at the ease in exchanging foreign-currency denominated loans for those in dollars, interest-rate swap spreads, and gauges of the cost to fund Treasuries through repurchase agreements.

Traders see the changes as allowing banks to move away from building huge coffers of ultra-safe debt and extend credit elsewhere in the system, as well as enabling them to beef up dealing Treasuries as funding trades become easier and cheaper. The knock-on wave to the financial sector could be in the order of $2 trillion in new liquidity, according to Deutsche Bank AG.

[...]

Basically, the Trump Administration is not so keen on many of the regulations that were brought in after the financial crisis of 2007/08. Even though it hasn't actually done very much yet, and we can't even be sure that he ever will (so many of the relevant departments are still full of empty offices because he's not getting on with the job of appointing the relevant officials), markets are starting to move and are giving us a hint of what the reaction might be.

(a spoiler here, providing background on what's going on)

The article specifically talks about some of the rules that require banks to protect themselves against the modern-day equivalent of a bank run: the so-called 'Supplemental Leverage Ratio'. In its simplest form (and that's all one needs to understand this), a leverage ratio is the size of a bank's capital (kinda what its owners have put in plus what it has earned in actual net profits over time) divided by the bank's assets (i.e. everything the bank owns). Anything the bank owns that isn't paid for from capital must be paid for using borrowed money, so it is a measure of how much money the bank has borrowed.

Basically, banks are required to keep leverage down (or get charged a cost for leverage). The idea is that of the market suddenly decided not to lend to this bank anymore, it would be able to hold out longer until it has to fold (and ideally, with this extra precaution, the market wouldn't get the idea in the first place).

The result is that in many markets, banks wanted to have a smaller balance sheet than they might otherwise. So for example, if a Japanese bank wanted to borrow US dollars from an American bank, the American bank might have turned them away or charged them more, because the American bank would have to grow its balance sheet to do it (borrow US dollars from Americans or the Fed, and add an asset in the form of a Japanese yen loan to the Japanese bank).

At other times, the banks might not even have wanted to hold very safe assets because they would have to borrow money to do so. There are other examples, but in short, it made lots of important transactions that happen under the radar more expensive and more difficult to do than it might have been otherwise.

The proposal by the US Treasury is to exclude cash and some safe assets (like US government bonds) from the calculation of the regulatory leverage ratio. So that would leave US banks free to have bigger balance sheets than before, provided that the things they buy with the borrowed money are relatively safe. The charts in the article are basically those transactions getting cheaper and easier to do, in anticipation of the rule change.

So, NSG, is this a win? Or a loss? In my view, I generally think that the banking regulations created in Basel and adopted around the world were a good and necessary reaction to make the financial system safer. But there are also lots of maybe unanticipated consequences that throw some sand in the gears for seemingly little benefit. Trump's and the modern GOP's view that financial regulation is mostly bad and should be repealed or pared back is dumb. But this tweak seems not so bad.

But what do you think?


PS: As an aside... I wonder whether there'd be any interest in NSG for a general finance and financial markets discussion thread. Might be one of those things that no one cares about, but I would be keen if I others were interested.

[Minoa]

The key aims for restoring confidence in the banks is to make sure that the debt to equity ratio of each company is 2 or less, and not negative (which indicates negative equity). Sorry for the complex terminology, it was something I learned from the Kmart video.

[Major-Tom]

My concern is that the regulations implemented after the recession and subprime mortgage crisis were absolutely necessary. Rolling many of these back could put us in the same position we were in during the Bush era, with predatory lenders preying on ill informed buyers, creating yet another sort of bubble.

Frankly, I don't care too much about what the financial markets think about regulation, it obviously isn't in their best interest to have more regulations. But having adequate consumer protections in place is in the best interest of the American people, especially the middle and working class.

Now, the good news here, the silver lining, is that these financial deregulations are quite small. I'm more worried about the long term, when Trump plans to further pursue more deregulation, that's when the real shit is going to break out.

[Risottia]

But what do you think?

I suspect Trump is a Soviet fifth-columnist trying to bring about the end of capitalism by flinging the Western economies into a new giant recession.

[Vassenor]

Can't tell if this is a "get rid of all the stuff Barry did" or a "fooled you, we really are the party of Wall Street after all!" thing.

[Aigania]

It's funny because I said something similar some days ago in the board of my region.

Trump seems and behaves as a caricature of the American Capitalism TM made by the left worldwide.

Stamping over the minimal regulations after the financial meltdown of 2007-2008 is irresponsible to say the least. It will fuel another one, and probably within his mandate.

P.S. Both are the parties of Wall Street.

[Neu Leonstein]

The key aims for restoring confidence in the banks is to make sure that the debt to equity ratio of each company is 2 or less, and not negative (which indicates negative equity). Sorry for the complex terminology, it was something I learned from the Kmart video.

Hmm... maybe try reading this bit. It's a really good explanation of what capital is (i.e. the thing you mean by equity).

And then, you could also read this and this (by the same guy) going through the merits, or lack thereof of the sort of hard capital ratios that you're talking about.

My concern is that the regulations implemented after the recession and subprime mortgage crisis were absolutely necessary. Rolling many of these back could put us in the same position we were in during the Bush era, with predatory lenders preying on ill informed buyers, creating yet another sort of bubble.

Frankly, I don't care too much about what the financial markets think about regulation, it obviously isn't in their best interest to have more regulations. But having adequate consumer protections in place is in the best interest of the American people, especially the middle and working class.

Consumer protection and rules against predatory lending are worth having, but they have very little to do with financial crises. A lot of bad stuff was done at the consumer level before 2007, but that wasn't really what did the banks in and caused the crisis.

And on the point about markets and regulation, I don't think that's true. Regulations are almost never good or bad for everyone, including in financial markets. They just change the incentives, and that tends to leave some people better off and others worse off. Same here: there are entities out there who are better off as a result of these sort of rules (mostly because they have less competition from big banks in buying certain assets or making certain loans), and there are others who are worse off. If you want to understand whether a regulation is a good thing or not, you can't jump to the conclusion that 'regulations are bad for markets'. You have to ask who is affected and how.

Otherwise you just run into the old chestnut of the two kinds of regulation:

I am working on a tentative theory of regulation. It goes like this:

1. There are two kinds of regulations: custom regulations and bulk regulations.
2. A custom regulation is designed to accomplish a particular goal. You want people to do something, so you write a rule mandating that they do it and punishing them if they don't. For instance, if you want U.S. companies to keep jobs in the U.S., you might write a rule to mandate that, and to "impose a 'very major' border tax on companies that move jobs outside the U.S." That is an example of a custom regulation, and it is good because it keeps jobs in the U.S.
3. Bulk regulations are the kind that you buy by the yard, ones that you measure by quantity rather than purpose. They don't have a purpose, really; they are just generic "red tape." These are the regulations that presidents frequently announce they will cut in half, or freeze with an executive order. They're the regulations that come not from a reasoned desire to achieve a particular goal, but from a pure impulse to regulate. Bulk regulations are bad because they prevent businesses from doing business-y things without accomplishing anything good.
4. All regulations are custom regulations.
5. All discussion of "regulation" is about bulk regulations, which do not exist.

Now, the good news here, the silver lining, is that these financial deregulations are quite small. I'm more worried about the long term, when Trump plans to further pursue more deregulation, that's when the real shit is going to break out.

It's coming, don't worry. But the problem is that when it comes, almost no one who will weigh in on the issue will actually know anything about what's going on. And so they'll all end up talking about the bulk regulations from the quote above.

[The Empire of Pretantia]

Can't tell if this is a "get rid of all the stuff Barry did" or a "fooled you, we really are the party of Wall Street after all!" thing.

Why not both?

[Minoa]

The key aims for restoring confidence in the banks is to make sure that the debt to equity ratio of each company is 2 or less, and not negative (which indicates negative equity). Sorry for the complex terminology, it was something I learned from the Kmart video.

Hmm... maybe try reading this bit. It's a really good explanation of what capital is (i.e. the thing you mean by equity).

And then, you could also read this and this (by the same guy) going through the merits, or lack thereof of the sort of hard capital ratios that you're talking about.

Okay, make it 1 or less for banks and buildings societies. I am aware that the desirable D to E ratio varies by industry.

[Neu Leonstein]

Okay, make it 1 or less for banks and buildings societies. I am aware that the desirable D to E ratio varies by industry.

Well, if you took the extreme stance that said only common equity is really capital, then you are proposing a debt-to-equity ratio of 1, which (if you dispensed with the distinction between debt and liabilities... maybe you would disagree with this?) is the same as a capital ratio of 50% (A=L+E & L/E =1 => E/A = 0.5). That is well beyond even the most extreme proposals made by anyone.

Currently, the way it works is that the assets of a bank are evaluated by how risky they are and how likely it is that they turn bad at the same time, to come up with a value they call 'Risk-weighted assets' (RWA). Then they calculate capital, of which there are a few layers. The most basic one is basically just equity and is called 'Common Equity Tier 1' capital (or CET1). Then the tier 1 capital ratio is calculated as CET1/RWA. And that is regulated, with Basel III saying that the minimum is 4.5%, but to make sure they don't fall below that buffer they have to have an extra 2.5% so that the real total is 7%.

Here's the banks actual CET1 ratios over the last few years (source):


To go from this to something like a simple 50% equity to total assets ratio would basically mean a complete overhaul to the way the US financial system and the US economy works. Banks just aren't like normal companies. Their business is to borrow money and lend it out again. So leverage is what they do.