CREDIT Suisse says it is no “magic bullet”. Bank of America insists it’s a “red herring”. And yet, all it takes to whip bond traders into a frenzy is the mention of a three-letter acronym – SLR, or supplementary leverage ratio.
The SLR is a requirement stemming from the Basel III accord that says United States banks must maintain a minimum level of capital against their assets without factoring in risk levels.
As a way to push banks to help the country get through the Covid-19 pandemic, regulators allowed them to temporarily exclude US Treasuries and deposits at the Federal Reserve (Fed) from the SLR denominator because they are the closest thing to risk-free assets.
In addition to helping banks continue to take deposits and lend during the health crisis, it also served to ensure they would help backstop the unprecedented fiscal and monetary policy support that flooded the financial system with cash.
This emergency move to rlax the SLR is set to expire on March 31 – and the Fed has been unusually silent about the SLR’s fate ahead of its policy decision next week.
Jelena McWilliams, chair of the Federal Deposit Insurance Corp (FDIC), said last week that she doesn’t see the need to extend the interim rule at the depository institution level, according to Politico.
Because the FDIC, Fed and the Office of the Comptroller of the Currency collectively approved the measure last year, markets have taken McWilliams’s stance as effectively ruling out a widespread extension. Even though she said the most important question rests with the Fed, which regulates the parent holding companies, that’s not quite right either, Mark Cabana, head of US rates strategy at Bank of America, told me in an interview, because holdings of Treasuries went up significantly at depositories over the past year, not dealers.
It makes sense why Cabana calls the SLR debate a “red herring.” It’s inherently complicated and requires a deep understanding of the private banking system and how the Fed’s balance sheet works – beyond the “money printer go brrr” meme.
When digging in, it becomes clear that the Fed has no easy solutions to maintain a healthy banking system and Treasury market. First, it’s important to understand the mechanics behind the Fed’s bond-buying programme. When it purchases Treasuries from a money manager, those securities become an asset on the central bank’s balance sheet.
The seller will deposit the cash it received at a bank, which is an asset for that bank and a liability for the Fed. In other words, quantitative easing boosts the asset levels of US banks, which, in turn, means they need to hold more capital.
There’s nothing wrong with the Fed, as a regulator, requiring that banks maintain adequate capital to avoid another financial crisis. But it’s a hard sell when the Fed, as the nation’s monetary policy authority, is forcibly increasing the asset base. This kind of internal struggle explains why the SLR exemption was put in place; it’s anyone’s guess what might have happened without it as the Fed expanded its balance sheet by almost US$3 trillion (RM12.34 trillion) in three months.
So, what to do? At first glance, the easy answer seems to be to just extend the SLR exemptions for Treasuries and reserves to avoid disrupting this market plumbing. By some measures, this break allowed banks to expand their balance sheets by as much as US$600bil – why mess with that?
However, the Fed created its own political problem by loosening its restrictions on banks’ cash distributions, which had been put in place after the pandemic. Banks are now buying back stock and distributing capital to shareholders, or, in SLR terms, willfully reducing their numerator. It stands to reason, then, that they could afford to have the denominator return to its usual form.
This is the argument from Democratic Senators Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio. In a letter to regulators last month, they argued “to the extent there are concerns about banks” ability to accept customer deposits and absorb reserves due to leverage requirements, regulators should suspend bank capital distributions.
Banks could fund their balance sheet growth in part with the capital they are currently sending to shareholders and executives. Another problem with extending the SLR exemption is that it truly benefits only a few large banks, as Zoltan Pozsar, a strategist at Credit Suisse, noted during a recent Bloomberg “Odd Lots” podcast. Not only is such favouritism politically fraught, but it runs the risk of falling short of what’s necessary to absorb the amount of cash hitting the financial system.
The SLR exemption is talked about as a “magic bullet”, he said, but that’s not really the case. “Maybe only reserves should exempted permanently, but not Treasuries – that would be more in line with the global standard, ” Pozsar said, floating an idea that has been bandied about by strategists. But that creates new issues in short-term rates markets.
Specifically, when overnight repo rates climb above the Fed’s interest rate on excess reserves, or IOER, banks have a natural incentive to use their cash to step into the repo market and capture a higher return. That behind-the scenes arbitrage might not happen if only reserves were exempt from SLR calculations because Treasuries typically serve as collateral for repo transactions.
In such a circumstance, “there’s regulatory benefit to holding cash”, Cabana said, and banks would be less likely to serve as the “repo police”. It has been less than two years since the repo meltdown of September 2019, which JPMorgan Chase & Co CEO Jamie Dimon blamed in part on regulations, and the Fed isn’t eager for a repeat performance. Dimon, for his part, raised the specter of having to turn away deposits at some point without SLR relief during the bank’s earnings call in January, which would obviously be quite a drastic business decision. ─ Bloomberg
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. The views expressed here are his own.