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Brad: Welcome to The Flip Side. I'm Brad Rogoff, Global Head of Research at Barclays, and today we have a special Flip Side, where I am joined by the former host of this podcast, Jeff Meli, now an NYU Stern School of Business Clinical Professor of Finance. We are going to talk about one of Jeff’s favorite topics today. How bank regulations are changing, and what it might mean for banks and for financial markets.

Jeff: I do love the topic, but that is partly because it is an important one for everyone.

Brad: Before we get started, full disclosure: Barclays is a global systemically important bank that operates in jurisdictions subject to prudential banking regulations. Our conversation today discusses changes to the US implementation of the post-global financial crisis bank capital framework, as discussed in an independent research report published by Barclays Research department. The views that we will express on this topic are our own and do not reflect the views of Barclays Bank PLC.

Jeff: Robust bank regulation is incredibly important to the overall economy and to financial markets. Banks safeguard deposits, which are a huge fraction of consumers savings, make trillions of loans to individuals and companies, and provide liquidity in financial markets, which investors rely on to buy and sell securities.

Brad: All of those things have been true for a long time, but we found out in 2008 maybe the level of “safeguarding” wasn’t as robust as it could be. Let’s take a little trip down memory lane. The rules governing banks were totally revamped after the global financial crisis, having learned that the old version allowed banks to become extremely risky, requiring massive taxpayer-funded bailouts.

Jeff: The most obvious change was requiring banks to operate with much more equity financing, meaning they were less levered and thus safer. But there were other changes to supervision as well, that also improved the stability of the system.

Brad: One important change was a new limit on banks exposures to low risk assets - designed to stop a repeat of 2008 when banks owned highly structured assets that were highly rated and therefore looked very safe but had serious hidden risks. This is necessary because historically banks capital charges, or the amount of capital they had to hold to absorb unexpected losses, were based on the risk of their assets, which can result in very high leverage for banks that own assets that appear safe.

Jeff: Regulators also introduced stress tests, where they impose hypothetical market shocks on the balance sheets of the largest banks to see if they can withstand serious volatility.

Brad: The new rules seem to have worked from a safety standpoint, but we are now seeing US regulators revisit some of these constraints. The most prominent change involves the enhanced supplemental leverage ratio, or eSLR, which builds on the broader SLR framework for the largest banks. In simple terms, the rule limits how much banks can expand their balance sheets, regardless of the riskiness of the assets they own.

Regulators are now making the eSLR less binding. The argument is that the leverage ratio was never supposed to be the main capital constraint on banks. It was designed as a backstop to the risk-based framework. These changes are intended to restore that balance and make the overall system work more as originally intended.

In addition, the stress tests are becoming more transparent, and the US version of Basel III, which takes effect in January, isn't necessarily a story of broad deregulation. By regulators' own estimates it still increases capital requirements for large banks, although some of that impact may be offset by changes elsewhere in the framework.

Jeff: One important question is why revisiting rules being implemented now? The current regulatory framework seems to be working: the largest banks have remained stable, even during periods of extreme market stress, and even as smaller banks experienced significant volatility.

Brad: I can’t argue that banks now perform better during periods of market stress, which used to be challenging for them. The logical conclusion is that this is because of changes to their business models that they adopted after the new rules took effect – notably, they take less overall risk now, particularly in their trading businesses.

Jeff: COVID was a good example of that: banks did quite well during the volatility. And the market volatility this year during the start of the Iran conflict is another example.

Brad: Both true, but if you think about your COVID example, are we only supposed to worry about banks not blowing up or should we also be thinking about them being able to help the economy through periods of stress.

Jeff: With banks I kind of think if it aint broke…

Brad: It might not be broken, but the regulations can be viewed as overbearing and overdone in parts. I see the coming changes as a somewhat overdue cleanup exercise. These rules were all individually well-intentioned, and most make sense in a vacuum. But so many rules changed so fast after 2008 that we needed to see how all the pieces fit together.

Jeff: At the time, it was a veritable alphabet soup of new rules and ratios: LCR, NSFR, HQLA, SLR, etc.

Brad: And the reality is, in some cases the rules just don’t make sense anymore. For example, the limit on safe assets was built for a different market environment. The assets that banks owned during the crisis don’t even exist any more: no bank does those types of highly structured deals.

Jeff: Well, as they say, hindsight is 20/20. But we are seeing some new forms of structured deals emerge that feel less risky, but haven’t been tested in times of stress. To be fair though, eSLR was originally meant as a backstop, not a primary constraint on banks.

Brad: But it ended up being binding on the largest banks, despite the fact that the safe assets they own now are mostly Treasuries and other US government obligations, like reserves held at the Fed, which are really and truly safe. The same holds for the other changes spurred by the GFC: these rules have been continuously evolving over the past 15 years as we learn how they work, and it is perfectly natural that at times that means revisiting some constraints – it doesn’t always have to be the other direction.

Jeff: I think where you’re off here is the motivation behind the changes to low risk assets. Policy makers are very worried about some recent episodes of dysfunction in the Treasury market. That is supposed to be the deepest and most liquid market in the world, but it hasn’t always worked like that recently.

Brad: There were brief periods of instability: in 2019, then again during covid, and during the regional bank crisis in 2023, when the market did not function that well.

Jeff: They were brief only because every time the Fed stepped in and stabilized the market. The covid experience was the most worrisome. Risky markets everywhere were falling: usually yields on US Ts go down during those periods…

Brad: Investors buy Ts because they are the safest assets: the flight to safety means T yields go down, and prices go up.

Jeff: But the opposite happened, because investors were also selling treasuries and there were no buyers: the largest banks were constrained and could not step in. Fast forward 6 years, and the US has issued trillions more debt thanks to huge deficits. Now the capacity to trade all these Ts is even more limited. I think regulators are trying to shore up this market by revisiting these rules. Keep in mind that the new Fed chairman wants to reduce the Fed’s footprint in markets: that means banks would need to pick up the slack, and because of the SLR they couldn’t…so now it is changed.

Brad: So we can have different perspectives on how the motivation and the changes may affect market functioning, but we want to be careful not to suggest that this is going to return us to the bad old days of risky banks: I still believe these assets are truly safe, and quite different from what banks owned pre-crisis.

Jeff: True for this round of changes. And if you are right about the motivation, then it ends here and I agree. But if I am right about motivation, this could be the first of several rounds of revisions, as policy makers are forced to choose between entity stability and market stability. Banks will run out of SLR capacity in like 18 months given the US’s enormous deficits: might require more changes like this over time.

Brad: Still, we are talking about Treasuries here…

Jeff: Sure, recall that interest rate risk played an important role bringing down SVB: they got caught owning Ts as rates rose and went bankrupt!

Brad: Ironically, that was partly due to the limits we are talking about. During covid, deposits increased a lot, and large banks couldn’t take them, because they faced these constraints. So smaller banks, which are generally less affected by this rule, took the deposits. But they also maybe less sophisticated at managing risks, and are less heavily supervised: so it is not a surprise that a handful mismanaged their exposures.

Jeff: So what do you think these changes mean for banks and for markets.

Brad: I think the biggest effect will be an improvement in bank profitability, which is measured as their return on equity. Before the crisis, it was high: around 15-16%. But since the new rules took effect it fell a lot, down to 9-10%. These changes will take some of the pressure off, which will be good for bank equity holders.

Jeff: I agree that will likely happen: these changes will allow banks to support more business with each dollar of capital: so they can do more trades, make more loans, etc. All that adds up to more profits. But I think that is only one effect. I also think markets will benefit from the additional capacity.

Brad: I am less convinced of that. Our research shows that as returns have fallen, banks have reduced reinvestment and returned more capital to shareholders instead. These rule changes will certainly create additional capacity, but capacity and growth are not the same thing. I think a lot of the benefit will show up through higher returns, buybacks and capital distributions, rather than a meaningful increase in organic growth.

Jeff: It is true that the reinvestment at the large banks is lower since the crisis, but isn’t that because the returns are lower? Banks are less attractive as an investment, so shareholders want profits returned to them…but that could change if the returns increase, right?

Brad: Not so fast: shareholders can be quite persistent about this. Think about what has happened in the energy industry, which is historically subject to massive booms and busts.

Jeff: When oil prices rise, producers all invest like crazy. Then their capacity comes on line, and guess what?

Brad: Prices fall, and they don’t make any money. Shareholders have been trying to short-circuit this process: insisting on capital discipline, which means limiting investment during boom times, and returning the profits to shareholders instead. You’re seeing much more discipline today than you would have seen in the past with a similar oil spike. I think the same thing will happen here. If banks start reinvesting, their margins will fall, and returns will decline as well. The only way to stop that is to keep reinvestment low.

Jeff: First, remember all the bond issuance we mentioned? The demand to trade and finance low risk assets is growing rapidly: I don’t see margins in that business being put under pressure because of this change. At most it keeps them steady for a time until the new capacity is utilized. I also think that there is a risk angle here. Investors don’t just care about returns, they care about risk adjusted returns.

Brad: I know where you are going: the volatility of bank earnings has fallen as returns have fallen – just as you would expect given their lower leverage.

Jeff: Yes but, the risk decline was smaller than the decline in returns.

Brad: Which is why shareholders demanded more payouts: the risk-reward tradeoff got worse for large banks, because the lower risk did not fully offset the lower returns.

Jeff: But you felt strongly that this round of changes at least is not going to seriously raise bank risks. If you are right, then risk might not rise. If you get more returns but not more risk, maybe that tradeoff gets better. The largest regional banks – not SVB clearly – are informative here. They also experienced a decline in returns when the new rules were adopted. But their risk fell by a lot, and overall, the risk-reward tradeoff improved. And guess what?

Brad: They now reinvest more than before, it is true. But I would hesitate to extend that to the largest banks.

Jeff: Why? Seems like a good analogy to me.

Brad: I think that you are too focused on financials. Regionals adopted new payout policies in an earlier era, and it is easier to stick with a high reinvestment policy than it is to institute one. The challenge is that banks are competing for investor capital at a time when some of the highest expected returns are being generated elsewhere, particularly in AI-related sectors.

Jeff: Ultimately, the question is whether these changes simply improve market functioning, or mark the beginning of a broader shift in how regulators balance financial stability against market capacity. But with Barclays tech analysts expecting more than $1tr in AI capex by 2028, there should be plenty of activity in equity and credit markets to drive returns for banks as well, potentially driving greater reinvestment.

Brad: And that's exactly what investors will be watching. Not whether banks become riskier, but whether a safer banking system can still provide enough capacity for a rapidly growing financial market. We’ll keep watching to see if that’s the case, and following how these rule changes ultimately affect banks. Appreciate you being here Jeff.

Clients of Barclays Investment Bank can learn more about this topic by reading our report titled “Capital Call” on Barclays Live.

Thanks for listening, and I’ll see you next time on the Flip Side.