The leash is snapping.
Washington is signaling a retreat from the post-2023 regulatory tightening. Market participants are no longer whispering about deregulation. They are pricing it into the bedrock of the financial system. Morgan Stanley’s Andrew Sheets recently highlighted a fundamental shift in how the U.S. government views bank balance sheets. This is not merely a cosmetic change to paperwork. It is a structural dismantling of the guardrails that defined the post-Silicon Valley Bank era. The implications for asset valuations are profound and perhaps dangerous.
The focus centers on the Supplemental Leverage Ratio (SLR). For years, the SLR acted as a hard ceiling on bank expansion by requiring lenders to hold a minimum amount of capital against all assets, regardless of risk. Regulators are now moving to exclude U.S. Treasuries and central bank reserves from this calculation. This move effectively hands the largest money-center banks a multi-trillion dollar credit card with no limit. When banks do not have to hold capital against Treasuries, their appetite for government debt surges. This suppresses yields in the short term but creates a massive concentration of risk on the private balance sheet. We are watching the socialization of liquidity risk in real time.
Capital is becoming a choice.
The Basel III Endgame is being rewritten before it was even fully implemented. Originally designed to force banks to use standardized models for credit and operational risk, the new mandate favors internal models. Internal models are the ultimate tool for regulatory arbitrage. They allow banks to determine their own risk weights, often resulting in lower capital requirements for the same level of exposure. Per reports from Reuters, the lobbying effort to dilute these standards has been the most expensive in a decade. The result is a financial system that looks sturdier on paper but possesses less actual cushioning for a hard landing.
Asset valuations are reacting with predictable exuberance. When capital requirements drop, the cost of carry for complex financial instruments falls. We see this most clearly in the private credit and collateralized loan obligation (CLO) markets. Banks are once again competing with shadow lenders by offering cheaper leverage. This creates a feedback loop where cheaper credit drives up asset prices, which then serves as collateral for even more credit. It is a classic expansionary cycle that ignores the deteriorating credit quality of the underlying borrowers. The market is ignoring the signal for the noise.
Projected Tier 1 Capital Ratio Impact (2025-2026)
The yield curve is a lie.
Artificial demand from banks is distorting the Treasury market. As banks load up on sovereign debt to optimize their new leverage ratios, the traditional relationship between inflation expectations and nominal yields is breaking. According to data tracked by Bloomberg, the term premium has turned negative despite persistent fiscal deficits. This is a technical anomaly driven by regulatory change, not a vote of confidence in long-term price stability. Investors who mistake this for a cooling economy are positioned for a violent correction when the supply of Treasuries eventually overwhelms this synthetic demand.
Bank stocks are the primary beneficiaries of this regime shift. The KBW Bank Index has outperformed the broader S&P 500 by 12 percent since the start of the year. Investors are betting on a return to aggressive share buybacks and increased dividend payouts. However, this capital return comes at the expense of systemic resilience. By hollowing out the capital buffers built over the last decade, the industry is trading long-term stability for short-term Return on Equity (ROE). The market is currently rewarding this trade, but the volatility of the underlying assets has not vanished. It has only been masked by the lack of regulatory friction.
Risk is moving into the shadows.
Deregulation does not eliminate risk. It merely relocates it. As traditional banks gain more flexibility, they are increasingly partnering with non-bank financial institutions to move riskier tranches of debt off their books. This ‘synthetic risk transfer’ allows banks to claim lower risk-weighted assets while maintaining the lucrative fees from loan origination. It is a shell game. The risk remains in the ecosystem, often held by pension funds and insurance companies that are less equipped to manage a liquidity crunch. The transparency of the 2024 banking reforms is being replaced by the opacity of 2026 bilateral agreements.
We are entering a period of high-velocity capital. The velocity is not driven by economic productivity but by the removal of friction in the financial plumbing. When the U.S. government eases regulations on bank balance sheets, it is effectively devaluing the insurance policy that protects the economy from banking failures. The ‘Thoughts on the Market’ from Morgan Stanley suggest that this trend will accelerate as the new administration takes hold. The focus is no longer on preventing the last crisis. It is on fueling the next expansion at any cost.
The next data point to monitor is the Federal Reserve’s H.8 report on January 23. This will provide the first granular look at how the top 25 domestic banks have adjusted their Treasury holdings following the preliminary SLR guidance. A sharp spike in commercial bank ownership of long-dated debt will confirm that the great unshackling is not just a policy proposal. It is a market reality.
