Regulators Retreat on Bank Capital; Trump Wants Fed Funds at 1%. Really?

June 30, 2025 | In this issue of The Institutional Risk Analyst, we do a quick review of about a couple of current issues in the political economy. We’ll be publishing a look at the consumer lenders for our Premium Service subscribers later in the week. We wish all of our readers a safe and happy Fourth of July holiday.  On July 4th, remember those who have defended our Union.

Mega Deficits: The Senate passed the “big beautiful bill” last night 51-49. Now it's up to the House whether they go home before July 4th. Senator Charles Schumer (D-NY) insisted that the 943 page bill be read aloud, his most significant contribution to date for better governance in the Senate. Despite such theatrics, Trump rolled the opposition in the Senate, but is this a good thing? Jim Lucier at CapitalAlpha:

"Investor perception of the One Big Beautiful Bill has been colored by the campers that we hear from. The problem is, they are not the happy ones. Instead, we hear complaints about Medicaid, SALT, and to a lesser extent, clean energy tax credits. We also hear generalized complaints from Republicans who feel that the bill is too big and bloated, costs too much, increases the debt, and is loaded with pork, social engineering, and “member priorities.” The bill polls badly in numerous surveys. We hear about budget cuts in important social programs. All of this is true. However, the bill also has fans who have been biding their time until the bill clears its Byrd Bath."

Our concern is that the BBB will increase the deficit by trillions and push LT yields and spreads up even more than already seen in 2025. Donald Trump's volatile style for governing has caused interest rates and, more important, spreads to rise considerably since January. Equities have regained 25% since Trump II began, but what is the cost of Donald Trump in the market for residential mortgages and credit more generally? Trillions...

WolfStreet: "The spread between the 10-year and 30-year Treasury yields has widened to 56 basis points, the widest spread since October 2021, except for the wild gyrations on April 2 Liberation Day." Trump says he wants to see FF at 1%.  But in the event, what happens to 10-year Treasury notes, which have been going sideways all year?

We can make a good case for slowly pushing fed funds down to ~ 3% to help originations, but the BBB may push the 10-year Tereasury over well over 5% by next year. Ask Bank of America (BAC) CEO Brian Moynihan how he feels about a 5-6% yield on 10-year Treasury notes.

Big Banks: The proposed rule to amend the enhanced supplementary leverage ratio (SLR) looks like a big concession to the banks by US regulators. The SLR measures a bank's Tier 1 capital against its total leverage exposure, without regard for the Basel III risk weight of the assets. The change caps the difference between simple leverage and the bogus Basel measure of "risk-weighted assets." This is a significant and historic retreat by US regulators.

The FDIC's stubborn retention of the basic leverage ratio in the early 2000s (h/t Sheila Bair) helped save a lot of banks from failure in 2008. Written opposition from former Vice Chairman Michael Barr came in a 3 ½-page statement, which strangely disappeared from the main page on the Fed’s website over the weekend. Barr said the plan would reduce capital requirements by 27% at the GSIB subsidiaries, resulting in a $210 billion drop in bank capital.

Barr also argued that the proposal is “unlikely to significantly enhance Treasury market intermediation, especially in times of stress.” Ditto. Banks have little reason to hold long-dated Treasury paper. He added, however, that he remains “open to working towards a much more modest eSLR reform if paired with Basel III implementation.”

Bank purchases of Treasury paper are basically limited to runoff from existing exposures and MBS payoffs. Notice that Treasury holdings by banks have rebounded to 2020 levels, but MBS is still down $600 billion vs pre-COVID levels, as shown in the chart below.

Source: FDIC

The proposal states that "a binding or near-binding leverage capital requirement can disincentivize bank-affiliated broker-dealers from intermediating in the U.S. Treasury market, which may create problems for the smooth functioning of U.S. Treasury markets and of U.S. financial markets more broadly." This is baloney.

Banks fund their primary dealer units on an arm's length and largely secured basis, so the aggregate net leverage of the dealer should not be a big consideration for a top-25 bank. The Treasury market/bank industry PR lobbyist angle on the Fed's eSLR proposal is a little fake-out for the financial media. This not about buying more Treasury debt but instead buying back more bank stocks. Sabe? Barr: "[M]uch of the capital that is freed up at the holding company level, where not otherwise constrained, is likely to be diverted to returning equity to shareholders, rather than intermediation."

As we wrote for our subscribers, you can see the financing for dealers and non-depository institutions from banks in "other loans" in the FDIC data, as shown below.

Source: FDIC

The problem with Basel and the current proposal is that the assets are risk weighted for credit loss, not market risk. Market risk is a secondary consideration in the economist daydream known as the Basel framework. Alongside the discussion of risk weighted assets, banks should be forced to publish a risk weighting of assets and liabilities based upon option-adjusted duration.

When Silicon Valley Bank had 40% of total assets in agency and government MBS ("Who Killed Silicon Valley Bank?) The IRA Bank Book Q1 2023"), that was a red flag with a zero risk weight for Basel purposes. The bank looked fine under the world view represented by the Fed's latest proposal. But nobody at the Fed seems willing or able to discuss duration in public much less before Congress. This might require a discussion of how the federal budget deficit threatens the safety and soundness of US banks.

Silicon Valley Bank

Source: FDIC (Q1 2023)

The eSLR change effectively means that the fantasyland world of risk-based capital under the Basel framework will always be the highest capital requirement for large US banks. The change does not address the true risk to large banks, namely market risk, and continues the Basel fixation with credit risk that is now some 40 years out of date.  Yet nobody at the Fed or other agencies seem willing to make obvious changes.

Many of our readers don't appreciate that in the 1980s our dear departed friend and fellow Lotosian, Fed Chairman Paul Volcker, helped to design the Basel Accord as a way of hiding the insolvency of the largest US banks, this the result of the LDC debt crisis. US banks were not allowed to write down LDC debt until after Volcker left office in 1989. But forty years later, the chief risk to US banks comes from the US Treasury and its alter ego at the Federal Reserve Board, and related market volatility.

The eSLR change does nothing to address the extreme market risk scenario caused by the Fed’s quantitative easing during 2020-2022, which led to the failure of Silicon Valley Bank and trillions in unrealized losses to US banks.  We agree with Governor Barr that the change does not necessarily make banks buy more Treasury debt, unless the Fed restarts QE. In the event, banks will be forced to purchase more Treasury debt for portfolio and then mostly T-bills as the core of the US economy hyperinflates. The dealer portfolios are a matter of indifference depending on your view of the probability of default for the United States.

We can make a good case for fed funds at 4% or lower. It is mainly a constraint on new asset creation/warehouse finance. The long end is where we price new bonds and loans. Since the Treasury is now adopting the approach to debt issuance of former Treasury Secretary Janet Yellen, meaning mostly T-bills, banks are likely to support this issuance to the extent to which deposits grow in the system. But as Yellen discovered and Treasury Secretary Scott Bessent now appreciates, the fact of the Treasury issuing mostly T-bills may not pull LT interest rates down.

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