February 2025

Regulation entails organizational effectiveness, a chain of command, and a structure for logistical support.”  Sun Tzu

Recently, there has been considerable discussion on both sides of the Atlantic about the need to review financial oversight and regulation.  This is a good thing, since the major reforms enacted in the febrile atmosphere of the post Global Financial Crisis (GFC) era were nothing if not a paean to the old adage that “good politics makes bad policy”.  Other than increased levels of capitalization – which would have been demanded by the market anyway – the cumulative impact of regulatory reform has been to greatly increase the complexity of the operating environment while pushing many activities (private credit, commodities trading, etc ) outside of the regulated sector.  The push to punish the large banks by encouraging new entrants has only resulted in the creation of a number of unprofitable, subscale challengers whose business is so concentrated that it is questionable whether they will survive their first encounter with an economic downturn.  And years were wasted in Europe creating Rube Goldberg-like resolution structures that failed at the very first hurdle, while in the US the complex system of competing regulatory agencies – itself a contributor the crisis – was not only not reformed but it was made more complex by dividing oversight of markets between agencies and then adding an extra layer (FSOC committee) to the mix.

So, what might a rollback look like?  Some obvious items have already started to take place such as the rollback of MIFID II rules on research and compensation caps in the UK, but these are quick fixes on the periphery that don’t meaningfully impact either the structure of markets or banks themselves.  To meaningfully “reform the reform” we will need to see the amendment or scuttling of regulations that were very high profile in their implementation, in some cases only recently.  That many of these are superfluous is beside the point.  It will require political will to undo what has only until recently been a high priority for policy makers.  Since 2010 more than $400 billion in fines have been levied against banks (i.e. their shareholders).  Will cash-strapped governments be willing to revert to pre-2008 penal practices with respect to fines?  And having now invested to make themselves fit for purpose in the new, more expensive regime, how aggressively will large banks be lobbying to lower the barriers to entry to their industry?  We like to remain optimistic that the various vested interests will see the benefits to improving market liquidity, lowering compliance costs and simplifying the process of opening bank accounts, but we will reserve judgement for the moment.

Elsewhere in February, markets began to get used to life in the new headline-a-minute world of the new US administration.  Data releases continued to show that the US inflation decline has stalled, but forward-looking sentiment indexes pointed to softness ahead amidst the uncertainty.  The BoE cut rates by 25 bp with indications that lower rates may lie ahead with the UK economy heading into a wall of new taxes in April, while Europe was stable.  In terms of broader market performance, equities were dragged lower by a tech stock correction, with the SPX down 1.4%.  Bond yields in the US were lower, despite the inflation data and driven more by the equity correction and creeping worries about the economy.  The current situation of relative valuations between Treasuries and stocks is not likely sustainable, which augurs for potential volatility ahead.

As predicted, European bank earnings showed continued strong results, with the Index trading to the highest levels in a decade.  Share buybacks and dividend announcements were in abundance while CEO’s eager to make the most of their newly reacquired MOJO made a number of unsolicited takeover bids (see our separate note on Bank M&A).  Thus far the action has been long on sizzle, short on steak, but as regular readers will note, we have long been advocates of sensible domestic consolidation within the European banking system.  Even though bank credit markets were fairly quiet, reflecting the already fully priced nature of securities, the fund’s A shares rose +1.79%, as a number of our idiosyncratic situations paid off.  For the month, credit contributed +157bp in gross performance while equities were +51bp amid banks’ 2024 results season.  Given recent developments, we see no reason to alter our approach, and we will retain our focus on idiosyncratic situations while maintaining the flexibility to respond to macro developments.