【Hotspot Analysis】U.S. Bank Capital Deregulation: Opportunity for Banks or New Risks?

Source：TradingView

Background

The U.S. Treasury market, the world’s largest bond market, is critical to the global financial system. However, current regulatory requirements limit banks’ balance sheet capacity, reducing their ability to hold Treasuries, particularly during periods of market stress. As a result, U.S. banking regulators, including the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC), are considering a proposal to lower capital buffer requirements for large banks. The primary goal of this proposal is to ease restrictions on banks’ Treasury market activities, thereby enhancing market liquidity and supporting financial system stability.

Proposal Details

The core of the proposal involves adjusting the Enhanced Supplementary Leverage Ratio (ESLR), a capital requirement that large bank holding companies must meet. Specifically, the proposal aims to reduce the ESLR from its current 5% (comprising a 3% base leverage ratio and a 2% additional buffer) by up to 1.5 percentage points, potentially bringing it to a range of 3.5% to 4.5%. The objective is to free up banks’ balance sheet capacity, enabling them to increase trading and holding of Treasuries, thus improving market liquidity.

This proposal primarily targets the eight U.S. Global Systemically Important Banks (G-SIBs), including:

• JPMorgan Chase
• Goldman Sachs
• Morgan Stanley
• Citigroup
• Bank of America
• Wells Fargo
• Bank of New York Mellon
• State Street Corporation

Potential Impact on the Banking Sector

Since Trump’s campaign, the market has factored in the possibility of bank deregulation, but year-to-date, the financial sector has only outperformed the S&P 500 by approximately 2%. This suggests that while expectations for deregulation exist, the market remains cautious and has not yet heavily bet on these changes. As the likelihood of the proposal’s implementation increases, it could have multiple implications for large banks.

First, lowering capital buffers directly frees up balance sheet capacity. Currently, the ESLR requires large banks to maintain a 5% leverage ratio, meaning $5 of capital for every $100 in assets. The proposed reduction to 3.5%-4.5% would lower this to $3.5-$4.5 per $100 in assets. This change frees up bank capital, enabling allocation to higher-yield activities. With a 1.5% reduction in the leverage ratio requirement, it is estimated that approximately $300 billion in capital could be released based on the total leverage exposure of U.S. G-SIBs. Banks can deploy this capital to increase Treasury trading, expand lending activities (such as corporate or mortgage loans), or invest in higher-return financial products (like derivatives or corporate bonds). These activities typically generate higher returns than holding large amounts of low-yield Treasuries, thereby directly boosting banks' net interest income or trading revenue.

Second, reducing capital buffers could indirectly enhance banks’ market-making capabilities in the Treasury market. As one of the most liquid markets globally, the U.S. Treasury market relies on large banks as primary market makers, earning profits through bid-ask spreads. Strict capital requirements have constrained banks’ balance sheet capacity, leading to reduced trading activity during market stress and missed profit opportunities. A lower ESLR would enable banks to hold larger Treasury inventories and increase trading frequency, particularly during volatile periods, potentially significantly boosting trading desk revenues.

Furthermore, lowering capital buffers could optimize banks’ capital structures and improve return on equity (ROE). Strict capital requirements force banks to hold more Tier 1 capital (e.g., common equity), increasing shareholder equity. However, if this capital is underutilized (e.g., tied up in low-yield Treasuries), ROE suffers. Reducing capital buffers allows banks to support the same asset base with less capital, thereby increasing ROE. Additionally, freed-up capital could be used for share buybacks or higher dividends, directly enhancing shareholder returns and further supporting profitability.

Potential Risks

Lowering capital requirements could weaken the banking system’s resilience, raising concerns among regulators and investors. Amid heightened global economic uncertainty (e.g., geopolitical conflicts or inflationary pressures), reduced capital buffers may make banks more vulnerable during economic downturns. If the market perceives this as an increase in systemic risk, banking stocks could face downward pressure, particularly for those heavily reliant on high-leverage trading, such as Goldman Sachs, which may experience more pronounced volatility.

Moreover, if the ESLR reduction proposal fails to pass, large banks’ profitability could be constrained. Limited balance sheet capacity would hinder their trading and market-making activities in the Treasury market, suppressing growth in trading and net interest income. This would also restrict banks’ ability to optimize their capital structures, leading to slower growth in ROE and earnings per share (EPS). In a market with high expectations for positive developments, failure to meet these expectations could trigger stock price declines, undermining investor confidence in the short term.