Raiding the piggy bank: Risky growth and bank deregulation

The three things investors should know this week:

1.     In the past few days, markets have been cheering at the prospect of deregulation, especially in the banking sector.

2.     Mr Scott Bessent, Mr Trump’s pick to lead the US Treasury, is a fervent advocate of deregulation. Rachel Reeves has also spoken about the need to reduce regulatory burdens.

3.     Reducing bank regulations is not the perfect silver bullet to attain growth and reduce deficits. Over the short term, it does improve numbers, but over the longer term, risks for economies and financial markets are increased.

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Summary

After the recent US election, the issue of banking deregulation has once again become popular. Deregulation can reduce deficits and stimulate growth without further onus to government balance sheets. The recent bank stock rally and comments from various officials suggest that a push for bank deregulation is gaining momentum. However, this adds risks to economies and financial markets.

This Week

With US markets closed on Thursday for Thanksgiving, news is scant this week. Investors will be looking for first retail results from Black Friday, as well as Minutes from the last FOMC meeting when the Fed lowered its key interest rate by 0.25%. The most important piece of information will come on Wednesday when the core personal consumption expenditure (Core PCE) is announced. We would also look at the Conference Board Consumer Confidence index in the US, especially expectations around equity performance which are at an all-time high. UK analysts might like a good look at the Lloyds Business Barometer on Friday.

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In the past few days, markets have been cheering at the prospect of deregulation, especially in the banking sector. The US election has become a catalyst for many government officials, across both sides of the Atlantic, to come out and advocate for deregulation. While upping economic and financial risk, it could be the key to unlocking economic growth in the years to come.

It’s all happened before.

The economic history of the 1980s is often summed up in one picture of Margaret Thatcher and Ronald Reagan dancing.

The US president and UK PM found themselves at the helm of very similar economies, drowning in the quagmire of stagflation that ensued after the US had demolished the gold standard a decade before. To this day, they are both credited with wide and bold market liberalisation reforms that allowed developed markets to regain their dynamic.

Looking back, it can be argued that the most significant (and less talked about) reform was that of bank deregulation. Desperately looking for growth, at a time when demographics were slowing down and the West could not antagonise Japan in terms of productivity, the greatest heads of state of their time found it in credit creation. Since the economic and financial disaster of the 1929 Great Depression, banks have been operating under a very strict regime. In the US it was called the Glass-Steagall Act which prevented banks from taking too many risks with their client’s deposits, and the framework spread across the world. A forbidden fruit, linked to the possible return of a Depression, deregulation started slowly. George Bush Senior continued the task, and Bill Clinton, eager to give every American a home completed it. By the end of his tenure, banks could leverage deposits to create credit and invest in the stock market. Banks, as expected, took too many risks, leading to the 2008 Global Financial Crisis. The aftermath saw them re-regulated and shackled to a harsh set of rules called Basel II and Basel III as well as to the Volcker Rule, which prevented commercial banks from investing too much in the stock market.

Much like the 1980s, today’s leaders find themselves faced with similar low productivity problems, even worse demographics, sluggish growth, competition from the East and complex geopolitics. Once again, they are likely to look at credit to save the day. The US in particular, seems ready to take a direct key page from Mr Reagan's playbook, bank deregulation (the other key page being dollar devaluation).

How credit works

A bank can create wealth literally out of thin air, in the form of credit. If Kate gives the Bank £100, the bank can then perform its function and, thanks to fractional banking which only compels it to hold a small amount in reserve, it can lend the rest away. In a heavily regulated system, the bank can create an extra £50-£70 worth of new wealth targeted at a very safe business, a 50% to 70% loan-to-deposit (LTD) ratio. The less regulation, the higher the amount of credit that can be created, up to nearly 120% LTD in 2007). The money can be invested also in riskier businesses, further unlocking growth, and some of it may even go to the stock and bond markets in the form of proprietary trading (which was severely curtailed under the Volcker rule).

The most important point is that this reduces the burden on the government to finance growth. After 2008, governments, private equity and shadow banks took it upon themselves to pick up the slack from a deleveraging financial sector.

However, bond markets have long been telling us that they feel uncomfortable with the debt mix. Yields are persistently higher, and the debt has become difficult to serve. The  US spends nearly double its annual economic growth in interest payments alone, as does France. The UK is also negative on this particular metric.

Why it’s relevant now

We have long wondered how long can developed economy governments keep paying for growth. Demographics are on the decline, and the third industrial revolution has only produced modest productivity gains.

What is the endgame of the rapidly accelerating debt? For the time being, governments seem to literally raid the proverbial piggy bank for a solution. If they relax post-GFC regulation, then they can kickstart growth without further risking the wrath of bond vigilantes.

The recent US general election has become a catalyst for such expectations. When Republicans held the White House from 2017 to 2020 they began this magnum opus by modestly deregulating US peripheral banks. The expectation now is that those efforts will be widened.

As such, bank stocks rallied significantly around the election.

In the last few weeks, expectations increased. Mr Trump’s Treasury nomination, Mr Scott Bessent, is an advocate of deficit reduction and bank deregulation (the latter being a prerequisite to the former unless growth rates collapse). In the last two weeks, UK Chancellor Rachel Reeves has twice said that bank rules are too tight and that regulators need to accept more risk. European Central Bank President Christine Lagarde acknowledged the possibility of lower regulation in a speech a few days ago.

Risky growth

Of course, deregulating banks is far from a silver bullet to attain long-term growth and reduce deficits. Risks are increased. Simply taking the debt from the government and putting it in banks (which had relinquished it to governments after 2008) makes the process essentially a shell game, designed to keep bond investors guessing where the next crisis might be, instead of focusing on known weaknesses. According to professors Reinhart and Rogoff, in the seminal “This Time is Different”, banking crises are more common in the US and the UK than in the rest of the world. This makes sense as those countries often choose to burden banks rather than their balance sheet. Overall, there’s little distinction between EM and DM in terms of Banking crisis occurrences. These usually happen within 5 years of major bank deregulation pushes.

Until credible gains can be attained from the AI revolution, it's a simple choice for governments: grow by debt or grow by credit, or not grow at all. The next step seems to be relying on credit.

PS: Many thanks to our own Kate Warner for coming up with the “Risky Growth” slogan.