The winners from a Republican sweep

The SPDR S&P Regional Banking ETF (KRE) rose more than thirteen per cent on the day after Donald Trump's election win, the best session for regional bank shares in years. Long-dated bonds sold off at the same time. The two markets were making the same bet from opposite ends.

The rally was broad. Shares of large lenders such as JPMorgan Chase and Wells Fargo rose sharply as well, and small-company indices, which contain many regional banks, outperformed the rest of the market. By the end of the week the Fed had cut rates by another quarter-point, but that was a sideshow. Investors were trading the prospect of a different set of regulators.

Banks bet on lighter rules

Investors expect a Trump administration to dismantle much of the Biden-era regulatory regime. Regulators appointed by Trump are expected to dilute or drop the 'Basel III Endgame' capital surcharges and ease off the tough antitrust scrutiny of bank mergers. Supervision of commercial property lending may soften too. For regional banks that means less friction and more room to return capital to shareholders.

How the rules got tougher

The current regime was shaped by the failures of Silicon Valley Bank and Signature Bank in March 2023, followed by First Republic in May. All three were mid-sized lenders that had grown fast under lighter supervision. Regulators responded with proposals to extend stricter capital rules to banks with more than $100 billion of assets, to require them to hold more long-term debt that could absorb losses, and to count unrealised losses on securities against their capital.

The Basel III Endgame proposal, published in July 2023, would have raised capital requirements significantly for the largest banks. It met fierce opposition from the industry and from within the Fed's own board. In September Michael Barr, the Fed's vice-chair for supervision, outlined a revised version that would shrink the increase and spare most regional lenders. Investors now expect a new administration to go further, or to shelve the project altogether.

Capital that regulators no longer require is capital that can be handed back. A bank that expected to hold several percentage points more equity against its loans can instead buy back shares or raise its dividend, and every dollar returned lifts earnings per share. That is the most direct route from Washington to a bank's share price, and it explains why the rally was sharpest among lenders just above the $100 billion threshold, where the proposed rules would have bitten hardest.

Why a steeper curve helps

The bond sell-off is the second half of the trade. Banks borrow short, through deposits, and lend long, through mortgages and business loans. When long yields rise faster than short ones, the gap between what they earn and what they pay widens. Regional banks, which depend more on lending income than on trading or investment banking, benefit most. A steeper yield curve also lets them reinvest maturing securities at higher rates, slowly repairing the unrealised losses that sank SVB.

The arrangement has a cost. Rising long yields also reduce the value of the bonds banks already hold, and they make commercial property loans harder to refinance. The gain in future income is real, but it arrives gradually, while the damage to existing assets is immediate.

The merger premium

Mergers are the other prize. Many regional banks are too small to spread the rising costs of technology and compliance, and the obvious remedy is consolidation. Deals have been slow to win approval under the current administration, and Capital One's proposed purchase of Discover, announced in February, is still awaiting a decision. Investors are betting that new appointees at the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation will clear such deals faster. Shareholders of likely targets would receive a premium; those of acquirers would gain from cost savings.

The losers from consolidation are harder to see. Borrowers in towns served by a few local banks may find fewer lenders competing for their business after a wave of mergers, and small businesses tend to rely on those relationships. Depositors could face lower rates on their savings. Antitrust officials weigh exactly these costs, which is why a change in personnel matters so much to the outlook for deals.

The 2018 precedent

There is a clear precedent for the rally. Bank shares surged after Trump's first victory in 2016, and in 2018 Congress raised the threshold for the strictest supervision from $50 billion of assets to $250 billion, with support from both parties. Banks such as SVB then grew rapidly under the lighter regime. Critics of that law argue it helped set up the failures of 2023. The same argument will be made against any new round of relief, and it may slow the process even under a friendly administration.

Commercial property is the risk

The strongest case against the rally is that deregulation cannot fix a bad loan book. Regional banks hold a large share of America's commercial property loans, and offices have lost value as remote work has cut demand for space. New York Community Bancorp showed earlier this year how quickly losses on such loans can erode confidence, needing a capital injection from outside investors to steady itself. Lighter supervision might delay the recognition of losses, but it will not make them disappear. If the economy slows, the losses will come faster than any regulatory relief.

The timing also matters. Rules can be written in a day, but rewriting capital regulation takes proposals, comment periods and final rules, which usually run to many months. Appointments need Senate confirmation. Markets have priced the outcome as though it were already done.

Regional bank shares now price in both lighter capital rules and a wave of mergers. If the new regulators move slowly, or commercial property losses come due first, much of the rally could unwind within the year. Watch for the first major bank merger announced after the inauguration: if it wins swift approval, the rally has a foundation; if not, holders of KRE should expect to give back at least half of this week's gains.