Markets Are Efficient--And Merciless. Deregulation Makes Omelets And Breaks Eggs.
KEY TAKEAWAYS
Banks exist primarily to lend money and earn spreads
Regulation suppresses bank profitability but reduces systemic risk
Private credit expanded because banks were constrained by regulation
Deregulation is now boosting traditional bank lending again
More credit supply does not eliminate credit risk–it redistributes it
MY HOT TAKES
Markets allocate capital more efficiently than regulators
Regulation smooths volatility but does so at the cost of efficiency
Credit cycles are driven by human behavior, not villainous actors
Deregulation always front-loads benefits and back-loads pain
The next credit problem will not be isolated–keep your eyes open 👀
You can quote me: “Deregulation feels like freedom until the market sends the bill.”
Revenge of the cockroaches. What do banks actually do? Well, I am sure that one of the first things that comes to your mind when thinking of a bank is that big safe door behind those velvet ropes. Yeah, in the most traditional sense, banks are a place to safe-keep your money and various other items of import. The latter is what is typically in those fancy safes while the former–your cash–doesn’t spend much time locked in vaults. No way, there is a far better use for it. Namely, to earn money… for the bank. I mean, why just let it sit there and collect dust when folks are lined up at the back door looking to borrow money and pay big fees for it. Bank savers are not stupid, they know what’s going on and they want a piece of the pie. After all, the bank is making money off of their funds. It is true that, in the most traditional sense, banks make money on their net interest margin. That is the difference in the interest it pays to borrow money (from you and me) and the interest it charges to lend that money, which can also be you and me in a mortgage loan, but it is also developers who take out construction loans, big and small companies who need money to finance projects and manage their cash ledgers etc.
Suffice it to say, banks are really in the business of lending money. But the problem is, lots of invasive regulation makes it very challenging for banks. Banks are public institutions, though technically they are private. They are so important to the economy that the government must carefully regulate them to maintain economic order. We all know what can happen when faith in banks sours. If you weren’t around in the Great Depression, you could just watch It’s a Wonderful Life, the Christmas classic where depositors lined up to collect their money at Bailey Brothers Building and Loan. Unfortunately, that money was not in the safe–it was loaned out. Technically, however, the bank is responsible to provide back all the funds. So what was George Bailey to do? Bank runs were quite common back in the day until the Government stepped in to provide a backstop with the Federal Reserve System. With that came a raft of restrictive measures to ensure that banks did not over-leverage, take too much risk, or worse yet, abscond investors’ money.
As is with most Government regulation it usually starts out tough in response to a failure. Then as the institutional memory of the event fades, regulations are eased. For the sake of this discussion, let’s assume that stricter regulation means less margin for banks, even though interest rates and market conditions are big factors. Getting back to regulation, as that eases, banks become more profitable. Turning the clock forward from the Great Depression and Bailey’s Falls / Pottersville, we arrive at The Global Financial Crisis.
The Global Financial Crisis unfolded in 2007-2009 after years of easy credit, aggressive leverage, and a housing boom built on increasingly fragile mortgage lending. Complex financial products tied to home loans spread risk across banks, insurers, and investors, masking how exposed the system had become. When housing prices fell and borrowers began to default, confidence evaporated, funding markets froze, and several major financial institutions failed or required emergency support. Equity markets collapsed, credit vanished, and fear–not liquidity as in the Depression era–became the dominant currency. In the wake of the GFC, bank lending, once again attracted invasive regulation to protect depositors. Governments imposed stricter financial regulations aimed at limiting risk and increasing transparency across the banking system. New rules raised capital and liquidity requirements, restricted proprietary trading, and expanded oversight of derivatives and large financial institutions. Banks were subjected to regular stress tests and closer supervision to monitor balance sheet strength.
Now, the Global Financial Crisis has gotten quite small in the rearview mirror and banks are looking to make a comeback. But wait, something else happened in the time between the GFC and today. Private lending! Alternative asset managers like Blackstone, Apollo, and KKR emerged as a key source of debt finance. Because they are not technically banks, regulatory requirements are almost non-existent. This allowed the private credit lenders to literally poach a key source of income from banks.
Now, taking a step back, these private lenders have done an amazing job and created great wealth for their investors. Not to mention that they provided liquidity capital which allowed the economy to grow. They probably could not have done that if the banks were not so busy climbing mountains of regulations while being tightly leashed with lending constraints. In the economic world which I like to occupy, this is proof that markets are efficient, and outside tampering (aka Government overreach) messes with efficiency of markets. In case you haven’t noticed by now, I, like most economists, am anti-regulation. We prefer to allow markets to clear inefficiencies.
A year ago the world was awaiting President Trump's inauguration after he staged a decisive election victory. Wall Street cautiously heralded the start of an era filled with less federal regulation. Banks would finally be able to operate unfettered by stifling regulations and escape Biden-era proposals that were even stricter. Now that time has come and banks have been freed up from some of the government’s most draconian restraints.
Earlier in the year, two auto industry credit failures (both for different reasons) brought to light the potential that perhaps poorly underwritten private loans were Wall Street’s next big flashpoint. The fact of the matter is this. There are indeed lots of dollars chasing too few good investing opportunities. High supply pushes prices down as investors clammer to lend money. “Lower prices” in this case mean that lenders are making riskier investments. Big Bank Boss Jamie Dimon wondered out loud to the press if there were more credit failures likely to come out of the woodwork–more cockroaches. Well, based on the following chart which I spotted in a Bloomberg article this morning, banks may have some of those cockroaches in their books as well.
It is clear that traditional commercial banks have made a comeback in recent years and that they are poised to take back even more market share in 2026. Is this a good thing or a bad thing? Well, if you were worried about the lax practices of private lenders, you should be more worried now. That’s even more capital chasing a finite number of quality lending opportunities.
What tends to get lost in these cycles is the uncomfortable tradeoff that sits right in the middle of them. Less regulation is, almost by definition, good for bank profitability, good for credit creation, and good for economic momentum–until it isn’t. Markets are far better at allocating capital than any rulebook drafted in Washington, but markets also correct excess brutally and without apology. Regulation smooths the ride at the cost of efficiency; markets enforce discipline at the cost of pain. You can pick your poison, but you don’t get to opt out.
When regulation loosens, competition returns quickly. Balance sheets grow. Credit officers get braver. Spreads compress. Return targets quietly assume that the good times will persist just a little longer than history suggests they ever do. None of this happens because bankers are reckless villains twirling mustaches in corner offices. It happens because incentives matter, memory fades, and capital does what capital always does, it moves toward yield. That process is rational, repeatable, and deeply human.
The problem is that markets don’t send gentle reminders when things drift too far. They send margin calls. They send downgrades. They send sudden liquidity vacuums where yesterday’s perfectly acceptable risk becomes today’s unfinanceable asset. Regulation, for all its inefficiencies, exists largely to slow this process down. Remove enough guardrails and the market will eventually put them back–only they’ll be installed overnight, at the worst possible moment, and paid for by shareholders.
This is where the omelet metaphor earns its keep. You don’t get one without breaking eggs, and deregulation is no different. The benefits arrive early and feel obvious. The costs arrive later and feel unfair. By the time they show up, the decision-makers who cheered the upside are often long gone, replaced by investors staring at red screens asking how something so sensible went sideways so fast.
That’s why the “cockroach theory” keeps resurfacing. Credit problems rarely announce themselves as isolated incidents. They appear quietly, dismissed as idiosyncratic, until another one scurries into view. And then another. By the time investors start flipping on the lights, the question is no longer whether there are cockroaches, but how many walls they’re hiding behind. The threat hasn’t disappeared. If anything, it has grown more likely as credit expands, standards soften, and competition intensifies across both banks and private lenders.
Heading into 2026, this tension will matter more than most people are willing to admit. Banks reclaiming market share sounds reassuring after years of private lenders dominating the space. But more balance sheet capacity chasing the same finite pool of borrowers doesn’t magically improve credit quality. It just redistributes risk. And when both regulated banks and lightly regulated lenders start competing for yield at the same time, the cycle doesn’t end with moderation–it ends with repricing. That is code for investor pain. 😉
None of this means the system is broken or that lending should grind to a halt. It simply means that efficiency comes with volatility, and volatility always finds its way into asset prices. Investors who cheer deregulation without acknowledging the bill that comes due later are only reading half the story. The market will do the rest of the reading for them.
Which brings us back, fittingly, to Bedford Falls. George Bailey didn’t lose because his model was flawed. He lost because time, fear, and human behavior collided all at once. The money wasn’t in the vault because that’s not how banking works. It was out in the community, doing exactly what it was supposed to do–until everyone wanted it back at the same time. In the end, it wasn’t regulation or markets that saved the Bailey Building and Loan. It was trust, patience, and a reminder that stability is fragile, even when intentions are sound.
The lesson still holds. Banks can be freer. Markets can be more efficient. But every omelet leaves shells on the counter, and every credit cycle eventually reminds us why they were there in the first place.
FRIDAY’S MARKETS
Stocks slipped slightly on Friday as investors readied themselves for the final week of trade in 2025 and hopes for a Santa Rally sat in the balance. Earlier gains were erased by stocks while Gold and Silver shone brightly as investors clamored for safe-havens (at least that’s what they told themselves).
NEXT UP
Pending Home Sales (November) may have increased by 0.9% after gaining 1.9% in the prior period.
Later in the truncated week we will get more housing numbers, FOMC meeting minutes, and weekly employment numbers. It will be a low-volume week, but low volume does not mean low-volatility–it could mean quite the opposite, so don’t lose focus. Start by downloading the attached calendar so you can be at the ready if the wind shifts.