Weak Lending, Weaker Recovery: The Real Cost

In the name of flexibility and liquidity, regulators are again considering easing leverage limits for major banks. The stated goal is to support stability and stimulate market activity, but this approach risks repeating past mistakes. A shift in regulatory posture may prompt banks to prioritise low-risk government debt at the expense of real-economy lending. The long-term consequences could prove damaging for growth, innovation, and economic resilience.

This article examines how reducing leverage constraints may inadvertently choke private sector credit and undermine the foundations of economic recovery — especially in an era when access to capital is critical for business investment, job creation, and technological advancement.

What Are Leverage Limits?

Leverage limits were introduced as part of post-2008 financial reforms to prevent excessive risk-taking and ensure banks maintain a stable capital base. Unlike risk-weighted capital requirements, which vary depending on the asset’s perceived risk, the leverage ratio is a simpler metric. It compares a bank’s core capital to its total assets, regardless of risk.

This ratio is intended as a backstop: a check on excessive growth in bank balance sheets. Banks must hold a minimum level of equity against all assets, whether those are government bonds or commercial loans. The idea is that no amount of clever risk-weighting should allow banks to overextend themselves without a sufficient buffer.

Incentives Shift When Rules Change

When leverage rules are relaxed, banks may respond by increasing their exposure to assets that are easy to hold and require minimal operational costs. Chief among these are government bonds, particularly U.S. Treasuries. Treasuries carry no credit risk and are highly liquid, making them an appealing option in a relaxed regulatory setting.

This shift in asset allocation is not merely theoretical. In 2020, the Federal Reserve temporarily eased the Supplementary Leverage Ratio (SLR), prompting a surge in Treasury purchases by large U.S. banks. Lending to the private sector, meanwhile, did not keep pace. These decisions weren’t irrational — they were shaped by regulatory design.

Private Sector Credit Gets Squeezed

Banks don’t have infinite capital. When they divert funds to government debt, less remains for lending to small businesses, startups, and mid-sized firms. These are the companies that generate most new jobs, drive innovation, and push productivity forward. They are also the most dependent on bank loans for growth, lacking direct access to capital markets.

Data from the Federal Reserve and European Central Bank show that during periods of regulatory easing, bank lending to SMEs either stagnated or declined. At the same time, balance sheets swelled with low-yielding government bonds. The outcome? A safer banking system on paper, but a weaker private sector in practice.

For example, during the post-pandemic recovery in 2021, the largest U.S. banks increased their Treasury holdings by over 40%, while business lending to firms with fewer than 500 employees grew by less than 3%. Similar dynamics occurred in the Eurozone. The structure of incentives discouraged productive risk-taking.

The Growth Impact Is Real

When lending tightens, the consequences ripple through the economy. Companies delay hiring, expansion, or investment in new technologies. Startups with viable ideas struggle to raise working capital. The effects are often hardest on regional economies, where banks play a vital role in local business financing.

This has macroeconomic consequences. Credit is the oxygen of the private sector. Without it, economies grow slowly — or not at all. Long-run productivity gains, driven by private capital allocation, give way to stagnation and reduced competitiveness.

Reduced lending also dampens government policy objectives. Green energy transitions, digital infrastructure, and housing supply all rely on private sector financing. Without a functioning credit channel, public policy goals become harder to achieve.

Misallocation and Systemic Risk

There is another danger: the illusion of safety. By encouraging banks to concentrate on Treasuries and similar instruments, regulators may be promoting systemic exposure to sovereign risk. While Treasuries are considered “risk-free,” this status depends on continued confidence in government solvency and fiscal discipline — both of which are under growing strain in the U.S., UK, and EU.

This creates a hidden fragility. If interest rates rise, or if political disputes trigger a debt ceiling crisis or delayed payments, bank portfolios heavily loaded with government debt could suffer substantial losses. Liquidity might dry up just when it’s needed most.

A diversified lending portfolio — including commercial and industrial loans — helps cushion these shocks. By contrast, a homogenous portfolio of government debt introduces correlation risk. The safety of the whole system then rests on a single assumption: that governments will never default.

Policy at a Crossroads

There is a legitimate case for reviewing capital rules. The banking system must be resilient but not frozen. Yet policymakers must balance simplicity with effectiveness. Overemphasising the leverage ratio at the expense of broader capital adequacy and stress testing risks undermining the system’s real-world functioning.

Reforms should aim to strengthen lending to sectors that drive sustainable growth — SMEs, clean energy, infrastructure, and innovation hubs. This could mean targeted incentives, adjusted risk weights for qualified loans, or regulatory carve-outs that recognise the strategic importance of credit flows.

Ignoring these needs in favour of short-term balance sheet optics would be a costly error.

What’s Next

• Regulatory decisions: The Federal Reserve, OCC, and European Banking Authority are currently reviewing capital adequacy rules. Watch for updates on leverage ratio reforms.

• Bank lending trends: Monitor quarterly data on commercial lending and SME credit to gauge whether banks are reallocating toward public debt.

• Political pressure: Legislators may push back against reforms that appear to favour Wall Street over Main Street.

• Macro signals: A slowdown in business formation or weak private investment could signal the unintended consequences of loosening safeguards.

Author: Brett Hurll