Bank deregulation: Bondholder friend or foe

Change is in the air for the US banking industry as the return of President Trump has fostered expectations for a looser regulatory environment. Although the administration has not issued formal recommendations, speculation is swirling. Treasury Secretary Scott Bessent wants to "responsibly deregulate the financial sector to accelerate what I call the re-privatization of the economy." That's open to interpretation, and incoming voices at the FDIC, SEC, Office of the Comptroller of the Currency (OCC), Federal Reserve and others presumably will have a say. But bondholders should carefully evaluate the changes as they could have a significant and lasting impact on the sector.

Pros and cons

Regulations are conventionally considered friends to creditors as they provide additional layers of protection and can promote healthier balance sheets. Loosening a rule, such as the amount of capital a bank must hold, could lower its safeguards and diminish its ability to absorb losses. In the worst case, this could lead to a banking crisis.

However, a moderation in the regulatory environment might lead to higher loan growth, including broader access to capital, improved capital markets activities, lower costs and improved profitability. These would be positives for economic growth, the health of the bank sector and, if managed conservatively, bondholders. Balance is key.

At this point, the banking industry is in wait-and-see mode. As it is generally easier to stop a proposal than undo an existing rule, several prominent ones, including Basel III, bank liquidity and regional bank long-term debt, are now in limbo. After that, or in concert, regulators will likely revisit existing statutes.

Other considerations

The financial sector has not been immune to the DOGE, with layoffs at the FDIC, OCC and the Consumer Financial Protection Bureau (which might be dismantled). While a reduction in boots-on-the-ground auditors and examiners might not create an issue on Day One, it would limit their ability to supervise banks, potentially missing problems that cause trouble down the road.

Bank M&A activity might increase in the new environment. The Trump administration wants a business-friendly approach, likely lowering regulatory hurdles to transactions across industries. The FDIC has already rescinded its latest bank merger guidance-issued just a few months ago in September-due to concerns it adds uncertainty to the merger process. This only makes consolidation of the more than 4,000 US banks more likely. But that could be a positive to investors. We would view a moderate reduction in the number of banks as likely strengthening the field as a whole and diversifying individual institutions.

We are at the very beginning of where the administration will alter regulation. Regulation likely will either level-off or decline. In both scenarios, we take comfort in the fact that banks are healthier compared to where they stood in the lead-up to the Global Financial Crisis. Capital is stronger, underwriting tighter and risk management practices generally improved. We do not expect drastic changes overnight, as policy-setting can take years to implement and bank leaders are unlikely to greatly deviate from existing risk policies, especially with the shadow of the 2023 failures still visible.

Investors would be wise to closely watch the situation develop and not deviate from tried-and-true vetting practice. While uncertainty increases, we are staying true to our fundamental research process. We don't just analyze the numbers; we scrutinize management teams, interpret policy implications and prepare for a multitude of scenarios.