An unnoticed triumph for banks
The Federal Reserve has cut interest rates by 50 basis points, marking its first reduction since 2020, which exceeded expectations of a 25 basis point cut and excited investors.
This decision coincided with a significant development where banks successfully negotiated capital requirements down from an initial demand of 19% to just 9%, allowing them to lend more and potentially increasing credit availability for borrowers.
As lending standards have started to ease, competition among banks is expected to rise, leading to lower interest rates for consumers.
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It’s certainly a big deal that the Federal Reserve cut rates for the first time since 2020. And the cut came in at 50 basis points instead of the widespread expectation for 25, adding to the market’s excitement.
However, investors overlooked another incredibly important development last month, banks secured a victory with regulators over capital requirements.
Regulators have been pushing for big banks to carry a lot more capital. They wanted to safeguard the economy from potential crises. Back in July 2023, regulators demanded a 19% jump in capital.
After a lot of back and forth, though, banks negotiated that number down to 9%, a huge retreat from the initial request.
The initial proposal of 19% would have tied up more capital, meaning lower returns on equity (“ROE”).
Put simply, banks would have been less profitable. And that means fewer people would be investing in banks, since investors would earn lower returns by investing in less profitable businesses.
That’s why banks launched an aggressive lobbying effort following the proposal’s introduction last year.
For every dollar in capital a bank has to tie up on its balance sheet, that’s a dollar it can’t deploy as loans into the economy.
With these lower capital requirements, banks can lend more compared with the initial capital hike suggestion.
And this is crucial for borrowers because banks can inject more capital into the system and have greater flexibility to lend. That should boost credit availability to borrowers.
As more banks start to lend more money, the element of competition also kicks in.
Borrowers will have more options to choose from. So banks will need to up the ante to attract borrowers by lowering the interest rates they offer.
The 9% capital requirement hike applies only to the biggest U.S. banks, including Bank of America (BAC) and JPMorgan Chase (JPM).
Smaller banks are on the hook for lower capital increases, as low as just 5% for some banks.
This may also change one of the U.S. lending environment’s biggest overhangs…
Longtime subscribers are familiar with one of our favorite ways to track credit standards, the Senior Loan Officer Opinion Survey (“SLOOS”).
The SLOOS is a quarterly survey from the Fed. In short, it gathers information about lending practices in the U.S… by asking loan officers if their lending rules have tightened, eased, or remained unchanged in the past three months.
Lending standards have been tightening for the past couple of years. We saw the most aggressive tightening in 2023.
45% of banks tightened lending standards in the first quarter of 2023. 46% made them even stricter in the second quarter, then 51% tightened them again in the third quarter.
And banks capped off their strict lending year in the fourth quarter with 34% of banks tightening once again.
However, 2024 has been a different story.
15% of banks tightened lending standards in the first quarter, 16% in the second quarter, and just 8% in the third quarter.
While standards were still getting tighter last quarter, it wasn’t nearly as aggressive. Take a look…
Lower capital requirements can lead to more credit competition… and looser lending restrictions for borrowers.
More accessible debt will encourage investment and growth for businesses, giving a boost to the market.
This could be the exact signal the market needed that it’s time to start borrowing from banks again.
Best regards,
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research