Federal Reserve's Regulatory Chief Resigns: Whither the Policy and the Market?

The architect of the post-crisis banking sector regulation said he would step down from office shortly, encouraging a rally in financials stocks due to expectations of a comprehensive loosening of market surveillance rules.

Kristian Rouz – Daniel Tarullo, a Federal Reserve governor and the mastermind behind the post-Great Recession’s tough market regulation, announced his resignation on Friday, the news spurring an immediate relief rally in financial stocks.

The resignation, effective this spring, will likely facilitate the new White House administration’s planning to deregulate the financial sector, allowing Wall Street enterprises to maximise their revenues.

Tarullo was in charge of safeguard and regulation measures, implemented shortly after the 2008 meltdown in the US financial sector, led by the mortgage collapse, most prominently, of the infamous private-public mortgage syndicates, Fannie Mae and Freddie Mac. Fed Chair Janet Yellen has repeatedly expressed her highest esteem of Tarullo’s actions as Fed governor, overseeing the major Wall Street banks.

Tarullo’s term was due to expire in 2022, yet, the 64-year-old policymaker opted to step down, having written in a letter to President Donald Trump he would resign "on or about" April 5.

This resignation will likely entail a major shift in US monetary policies. Trump and his team and supporters have multiple times reiterated the excessive regulation of US banking sector – including banks and non-bank lenders – has been choking economic growth, mainly because smaller lenders could not increase their volumes of lending. All banks and non-banks, under Tarullo’s rules, had to maintain higher reserve rations, meaning they would sit on cash without being able to use it for business investment.

While the tough rules did little to impair or curb the risky behaviours practices by some major US lenders, the smaller community banks and credit unions were unable to finance small business ventures. Trump’s team, meanwhile, in their effort to revitalise the Main Street economy, proposed the so-called CHOICE Act, providing that lenders would be responsible for their risky behaviours, rendering public bailout scenarios impossible.

"Deregulate at the financials" own risk’ is Trump team’s key approach to banking sector surveillance. Tarullo’s resignation, therefore, paves way to an easier policy readjustment, and such a development does not come as quite a surprise to market participants and observers.

"Tarullo is a bank regulator and the perception in the marketplace, rightly or wrongly, is that he is for tighter regulatory oversight and lower margins in the banking business," Neil Dutta of Renaissance Macro Research commented on the news. "Someone with more lax attitudes on regulation is likely to come out of this. Buy banks – the dog is running without its leash on."

Indeed, financial stocks posted robust gains in Friday’s trading as investors are anticipating an expansion in business activity and higher returns and earnings for banks. A prominent exchange-traded find (ETF), Financial Select Sector SPDR, added 0.6pc, and overall financials rallied roughly 0.3972pc on Friday only, according to KBW Bank Index.

Bank of America and Citigroup added roughly 1pc each within thirty minutes after the announcement.

In terms of policy, Tarullo’s resignation gives Trump an opportunity to put his pick in charge of regulation, however, it is not clear yet if Trump’s choice would favor the Republican-proposed CHOICE Act, or policy would go in a different direction. Yet, a deregulation in the banking sector is definitely taking place in the near-term. Trump might opt for greater deregulation for small banks, while actually maintaining the reserve requirements for bigger banks at their current levels, which might, however, stir a debate over fair competition terms.

In addition, deregulation will inevitably contribute to an increased volatility in the banking sector, and the banks’ own responsibility for their actions will boost the demand for insurance. Insurers are, therefore, also a good investment in a more tumultuous environment. Moreover, Tarullo’s stepdown will indirectly contribute to a further slide in bond values, which are now looking almost as a conscious goal of the Trump administration, as higher yields push natural interest rates up, putting more pressure on Fed Chair Yellen.

Yellen was put into office by the Obama administration and drew harsh criticism from Trump for her dovish approach to policy, which makes, in President’s words, "making Obama look good."

Tarullo resigned shortly after Trump signed an executive order on deregulation of the economy, which implies that for each one new regulation, two old regulations must be abolished. Moreover, the resignation comes just a week after Trump approved – via an executive order – a review of the Dodd-Frank Act, which the GOP are hoping to replace with their CHOICE legislation.

Investor sentiment reflects their perception of Trump as bringing the market back into the economy, with broader money-making opportunities in an increasingly risky environment. The actual refurbishment of the banking sector regulation is likely to be macroprudential, meaning smaller banks are a place to be, as a complete removal of Wall Street regulation in questionable.