Raiding the piggy bank: Risky growth and bank deregulation

It’s all happened before.

The economic history of the 1980s is often summed up in one picture of Margaret Thatcher and Ronald Reagan dancing.

The US President and UK PM found themselves at the helm of very similar economies, drowning in the quagmire of stagflation that ensued after the US had demolished the gold standard a decade before. To this day, they are both credited with wide and bold market liberalisation reforms that allowed developed markets to regain their dynamic.

Looking back, it can be argued that the most significant (and less talked about) reform was that of bank deregulation. Desperately looking for growth, at a time when demographics were slowing down and the West could not antagonise Japan in terms of productivity, the greatest heads of state of their time found it in credit creation. Since the economic and financial disaster of the 1929 Great Depression, banks had been operating under a very strict regime. In the US it was called the Glass-Steagall Act which prevented banks from taking too many risks with their clients’ deposits, and the framework spread across the world. A forbidden fruit, linked to the possible return of a depression, deregulation started slowly. George Bush Senior continued the task, and Bill Clinton, eager to give every American a home, completed it. By the end of his tenure, banks could leverage deposits to create credit and invest in the stock market. Banks, as expected, took too many risks, leading to the 2008 Global Financial Crisis. The aftermath saw them re-regulated and shackled to a harsh set of rules called Basel II and Basel III as well as to the Volcker Rule, which prevented commercial banks from investing too much in the stock market.

Much like the 1980s, today’s leaders find themselves faced with similar low productivity problems, even worse demographics, sluggish growth, competition from the East and complex geopolitics. Once again, they are likely to look at credit to save the day. The US, in particular, seems ready to take a direct key page from Mr Reagan's playbook; bank deregulation (the other key page being US Dollar devaluation).

How credit works

A bank can create wealth literally out of thin air, in the form of credit. If Kate gives the Bank £100, the bank can then perform its function and, thanks to fractional banking which only compels it to hold a small amount in reserve, it can lend the rest away. In a heavily regulated system, the bank can create an extra £50-£70 worth of new wealth targeted at a very safe business, a 50% to 70% loan-to-deposit (LTD) ratio. The less regulation, the higher the amount of credit that can be created, up to nearly 120% LTD in 2007. The money can be invested also in riskier businesses, further unlocking growth, and some of it may even go to the stock and bond markets in the form of proprietary trading (which was severely curtailed under the Volcker rule).

The most important point is that this reduces the burden on the government to finance growth. After 2008, governments, private equity and shadow banks took it upon themselves to pick up the slack from a deleveraging financial sector.

However, bond markets have long been telling us that they feel uncomfortable with the debt mix. Yields are persistently higher, and the debt has become difficult to serve. The US spends nearly double its annual economic growth in interest payments alone, as does France. The UK is also negative on this particular metric.

Why it’s relevant now

We have long wondered how developed economy governments keep paying for growth. Demographics are on the decline, and the third industrial revolution has only produced modest productivity gains.

What is the endgame of the rapidly accelerating debt? For the time being, governments seem to literally raid the proverbial piggy bank for a solution. If they relax post-GFC regulation, then they can kickstart growth without further risking the wrath of bond vigilantes.

The recent US general election has become a catalyst for such expectations. When Republicans held the White House from 2017 to 2021, they began this magnum opus by modestly deregulating US peripheral banks. The expectation now is that those efforts will be widened.

As such, bank stocks rallied significantly around the election.

In the last few weeks, expectations increased. The US President's Treasury nomination, Mr Scott Bessent, is an advocate of deficit reduction and bank deregulation (the latter being a prerequisite to the former unless growth rates collapse). In the last two weeks, UK Chancellor Rachel Reeves has twice said that bank rules are too tight and that regulators need to accept more risk. European Central Bank President Christine Lagarde acknowledged the possibility of lower regulation in a speech a few days ago.

Risky growth

Of course, deregulating banks is far from a silver bullet to attain long-term growth and reduce deficits. Risks are increased. Simply taking the debt from the government and putting it in banks (which had relinquished it to governments after 2008) makes the process essentially a shell game, designed to keep bond investors guessing where the next crisis might be, instead of focusing on known weaknesses. According to professors Reinhart and Rogoff, in the seminal “This Time is Different”,  banking crises are more common in the US and the UK than in the rest of the world. This makes sense as those countries often choose to burden banks rather than their balance sheets. Overall, there’s little distinction between EM and DM in terms of banking crisis occurrences. These usually happen within 5 years following the completion of major bank deregulation pushes.

Until credible gains can be attained from the AI revolution, it's a simple choice for governments: grow by debt or grow by credit, or not grow at all. The next step seems to be relying on credit.

George Lagarias – Chief Economist

Market update

Equities rose by +2.3% last week in a quiet period for major macroeconomic releases. In the US, much of the focus at the start of the week was on the earnings of Nvidia, which reported its earnings on Wednesday. The financial results of the chipmaker giant received mixed reactions from markets and saw shares of the company end the week roughly where it started. By the end of the week, US stocks rose by +2.5% in Sterling terms on strong returns from other sectors, including consumer staples and materials. UK stocks rose by around the same amount, shrugging off a hotter than expected inflation report, and weaker than expected retail sales. Emerging market stocks rose by +1.0%, while Europe and Japan performed worse, returning +0.2% and -0.1% respectively.

10-year government bond yields fell back modestly across the UK and US over the week, after yields tested levels near 4.5%. UK 10-year yields fell by 9 basis points, while US 10-year yields fell by 3 basis points.

Gold and oil saw a partial reversal of their post-election trend, both rallying strongly. Gold rose by +6.6% in GBP terms while oil rose by +7.1% over the week.

Macro news

UK Headline CPI inflation rose from 1.7% to 2.3% YoY in October (above the consensus expectations of 2.2% and the Bank of England's forecast of 2.2%). The acceleration in inflation was almost entirely due to a rise in regulated energy prices. Core inflation, which excludes volatile energy and food items, rose slightly from 3.2% to 3.3%. Inflation in services moved up from 4.9% to 5.0%. Following the data release, investors re-priced their rate cut expectations to around 0.6% of BoE rate cuts by the end of 2025, equivalent to two to three 0.25% cuts.

GDP growth for the third quarter of the year came in weaker than expected at 0.1% QoQ (below consensus of 0.2%). The weakness was mainly explained by net acquisitions of valuables, which subtracted 1.1% from growth. However, all the main components of domestic demand showed positive momentum: private consumption rose by 0.5%, government consumption by 0.6% and gross fixed capital formation by 1.1%, led by a 1.2% increase in business investment.

The week ahead

The Federal Reserve will be in focus this week, as the minutes from the last FOMC meeting will be released on Tuesday. Core PCE, the Fed’s preferred inflation measure will also be released the next day, on Wednesday.