Will New Rules for Smaller Banks Hurt the Economy?

May 11, 2023

Volatility in the regional banking sector—and the possibility of new regulations—has broader implications for credit availability and economic growth.

Vishy Tirupattur

Key Takeaways

  • The recent sale of First Republic offers some clarity for the banking system, but investors remain concerned about regional banks.

  • Regulators are expected to impose new rules on regional banks at a time when lending standards are already tightening.

  • Slower growth in credit has broader implications for bond markets and economic growth. 

Investors remain concerned about the banking sector as institutions manage a changing interest-rate environment, slowing economy and four bank failures. This uncertainty also raised the possibility that small- and mid-size banks will see tighter regulations. This has implications not just for the banking sector but, arguably, for the broader economy. Here are some of the most common questions from investors looking to make sense of potential new bank rules. 

Are regional banks still in trouble?

The collapse of four U.S.  banks—with more than $500 billion in combined assets—in the last few months is hard to dismiss. Last week’s sale of First Republic offered some closure for investors worried about how its losses would affect the country’s banking system. To quote Federal Reserve Chair Jerome Powell, this resolution was “an important step toward drawing a line” under banking sector volatility. However, investors’ fears have not dissipated, and their concerns are now focused on regional banks’ capital and operating models.  

The turmoil in the banking system is especially troublesome in the context of a slowing economy, with interest rates that have risen sharply over the last year, including an additional hike in early May. While the Fed has not signaled the direction of its next move, it’s not likely to cut rates this year. Rather, Morgan Stanley believes the Fed will hold rates where they are through the end of this year before gradually bringing them down.

Will there be new banking regulations?

The Fed is proposing to extend tighter rules to smaller banks—those with $100 billion to $700 billion in assets—bringing them in line with the regulatory restrictions on large banks.

The recent review of the supervision and regulation of Silicon Valley Bank provides an early look at future bank regulation. It makes it clear that tighter regulation is coming, with particular focus on managing interest rate and liquidity risk, which will affect both sides of a bank’s balance sheet. On the liabilities side, banks would need more long-term liabilities that can be converted into equity in the event of stress, locking in a higher cost of capital. On the assets side, banks would need to hold sufficient high-quality liquid assets (such as cash and U.S. equities) to fund the daily cash outflows in a hypothetical 30-day scenario. The pressure on both sides of the balance sheet suggests a squeeze on margins and profitability.

It’s worth highlighting that there is uncertainty about when such regulatory changes will go into effect. In our view, at least some of these changes are unlikely to require legislation and thus face fewer hurdles. The timing of implementation depends on when they are proposed and the standard notice and comment periods in the rule-making process. That said, markets are forward-looking and will likely move in anticipation of these regulatory changes.

What does tighter credit mean for the bond market?

With higher liquidity requirements, we expect to see bank demand for Treasuries increase relative to other assets, with banks favoring shorter-dated Treasuries. Similarly, we expect less demand for longer-duration securities such as agency mortgage-backed securities (MBS) and the long-term portions of securitized credit assets.

Bottom line: Volatility in the regional banking sector is likely to result in tighter credit conditions, due to both lingering liquidity stress and regulatory changes to come. The former is already playing out and the latter is likely to weigh on economic growth over the longer term.

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