Bank Regulatory Reform and Capital Requirements: How Scrapping Dual Standards Could Reshape the Sector and Boost Shareholder Value

The U.S. banking sector stands at a crossroads. For years, the "dual capital standards" framework—combining leverage-based and risk-based capital requirements—has imposed a complex, often counterproductive regulatory burden on large banks. However, recent calls to scrap or recalibrate this system, particularly the flawed dual capital requirement structure proposed in July 2023, could unlock a new era of efficiency, profitability, and competitive balance. For investors, this shift represents a pivotal opportunity to reassess the sector's long-term potential.

The Problem with Dual Capital Standards

The dual capital standards require banks to meet the higher of two capital measurement methods: a modernized risk-based approach or an outdated standardized approach. This structure, criticized by U.S. Treasury Secretary Scott Bessent as "flawed," has artificially inflated capital aggregates and preserved outdated rules as the binding floor for many institutions. The result? A regulatory framework that stifles innovation, limits lending, and pushes financial intermediation to less-regulated non-bank entities.

For example, the enhanced supplementary leverage ratio (eSLR) for globally systemically important banks (GSIBs) has long acted as a binding constraint. Requiring a minimum of 5% for holding companies and 6% for subsidiaries, these thresholds have forced banks to prioritize high-risk, high-return activities to meet capital ratios. This undermines the original intent of capital requirements—to promote stability by ensuring banks can absorb losses.

The Case for Reform

The proposed recalibration of eSLR standards, which would align them with 50% of a bank's risk-based surcharge, aims to address these inefficiencies. By reducing the binding nature of leverage-based requirements, regulators could:
- Free up capital for low-risk activities: Banks would no longer face disincentives to participate in critical markets like U.S. Treasury intermediation, which supports liquidity and economic growth.
- Simplify compliance: A unified capital framework would reduce the administrative and financial costs of maintaining two parallel systems.
- Enhance flexibility: Banks could allocate capital more effectively, balancing risk and return while maintaining solvency.

The Treasury's push to "opt in" smaller banks to a streamlined capital framework further underscores the potential for broad-based reform. Community banks, long constrained by rigid rules, could see reduced compliance costs and expanded lending capacity, bolstering their role in local economies.

Implications for Shareholder Value

For investors, the scrapping of dual capital standards could reshape the competitive landscape in three key ways:

1. Increased Profitability for Large Banks:
   Banks like JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) stand to benefit from reduced capital constraints. With more flexibility to allocate capital, these institutions could expand lending, invest in fintech partnerships, and diversify revenue streams. A analysis shows how regulatory clarity has historically correlated with stock performance.

2. Renaissance for Community Banks:
   Smaller banks, such as Zions Bancorp (ZION) and PNC Financial Services (PNC), could see a resurgence as regulatory burdens ease. These institutions are better positioned to support small businesses and local markets, which could drive long-term growth and shareholder returns.

3. Reduced Systemic Risk:
   By aligning capital requirements with actual risk profiles, the new framework would mitigate the "too big to fail" dynamic. This could stabilize investor sentiment, particularly in light of the 2023 banking collapses, and reduce volatility in bank stocks.

Strategic Investment Opportunities

Investors should consider the following strategies:
- Position in Large Banks: Look for institutions poised to capitalize on regulatory relief. Banks with strong risk management frameworks, like Goldman Sachs (GS) or Morgan Stanley (MS), may outperform as they reallocate capital to higher-margin activities.
- Support Community Banks: Smaller banks with solid balance sheets, such as KeyCorp (KEY) or U.S. Bancorp (USB), could see improved margins and valuation multiples.
- Monitor Regulatory Developments: The outcome of ongoing debates over Basel III alignment and Treasury-led reforms will shape the sector. A could highlight which institutions are best positioned for the new rules.

Conclusion

The potential scrapping of dual capital standards marks a turning point for the banking sector. By reducing regulatory friction and aligning capital requirements with risk, the reforms could unlock significant shareholder value while promoting financial stability. For investors, this is a chance to invest in a sector poised for reinvention—one that balances growth, innovation, and resilience in an evolving economic landscape.

As the Treasury and regulators finalize their approach, the next few months will be critical. Those who act now to position their portfolios for a post-dual-standard era may find themselves well ahead of the curve.