WASHINGTON — When the Federal Reserve allowed capital relief provided to banks at the outset of the pandemic to lapse this past March, the central bank said a permanent fix was likely needed to account for the massive influx of cash to the financial system.
But months later, the Fed has not moved to alter the supplementary leverage ratio, an extra buffer imposed on the biggest banks that is supposed to serve as a secondary capital requirement. The SLR levies the same capital requirement on all bank assets, regardless of their risk.
The Fed’s inaction has become a headache for several big banks, making their SLR requirements a so-called “binding constraint” instead of relegating the ratio to its usual backup role. That means those banks have fewer incentives to invest in safe assets, like U.S. Treasuries, and more incentives to take on more risk.
At issue is the Fed’s asset purchases that it started conducting in March 2020. When the Fed purchases U.S. Treasuries and mortgage-backed securities, it drives reserves into the banking system, which is expected to absorb them.
Recognizing that its gargantuan asset purchases could result in balance sheet pressures for banks, the Fed in April 2020 allowed bank holding companies to exclude Treasuries and reserves held at the central bank from the SLR calculation, enabling them to expand their balance sheets and help support the economy during the pandemic. Those exclusions expired earlier this year, but the Fed pledged at the time to explore ways to prevent the SLR from overtaking risk-based capital requirements.
“Right now, the system can't hold the amount of cash that it has without a change,” Fed Gov. Randal Quarles
Fed Chair Jerome Powell said Wednesday that the central bank was looking at “if there are ways we can address liquidity issues through that channel,” but declined to say whether or not the Fed was still pursuing permanent adjustments.
Without a fix, it creates “perverse incentives” for banks to take on riskier activity, such as loans as opposed to safer investments, like Treasuries, said Francisco Covas, executive vice president and head of research at the Bank Policy Institute.
“While the Treasury market has grown significantly, ... the banks have been reducing their capacity to intermediate in markets, just because a binding SLR encourages banks to shift their balance sheet towards activities that yield higher returns, but have more risk,” he said.
Since the temporary relief expired without a permanent fix from the Fed, the SLR has run up against the risk-based capital requirements in particular for JPMorgan Chase, Bank of America, Goldman Sachs and Morgan Stanley.
However, some note that codifying carve-outs to the SLR might offset the point of the rule entirely.
“Whenever you have a backstop, sometimes that backstop is going to bind, and that’s okay, because the alternative is, if you just keep lowering the backstop, then it’s not a backstop anymore,” said Jeremy Kress, a business law professor at the University of Michigan and a former Fed attorney.
Kress also noted that the consequences that banks predicted would result from the Fed’s decision not to extend the temporary SLR relief never actually materialized. Prior to the March expiration of the temporary exemptions, banks had warned that their ability to accept deposits and lend to customers and businesses would be limited if the relief were to expire.
“The banks created all this hysteria about the terrible things that would happen if the SLR exclusions were allowed to expire ... and now, eight months later, it’s pretty clear that those dire predictions didn’t come true,” he said. “It’s a little bit of a case of crying wolf.”
The SLR has also led banks to push deposits to nonbanks, mainly money market mutual funds, said Covas. The Fed has highlighted money market funds
“The Fed is kind of working against itself in several ways,” said Steven Kelly, a research associate at the Yale Program on Financial Stability. “Really, it's just pushed assets into money market funds, the same money market funds that the Fed is saying, ‘These are bad. We need to we need to think about the size of this market.’”
While banks are bound by regulations and capital requirements, money market funds and other nonbanks don’t have the same safeguards, raising questions about what level of government intervention might be needed in the event of another economic crisis if deposits keep shifting away from banks.
“I think anytime that things like the leverage ratio are misaligning incentives, to the extent that we have other actors in the economy that are that are not bound by such regulations and that creates sort of an open opportunity for them, I definitely think that that's an issue,” said Sean Campbell, the chief economist and head of policy research at the Financial Services Forum.
Many suspect that the Fed has not moved to make any changes to the SLR — despite the fact that it is quickly becoming binding for some banks — because it is waiting to see whom President Biden might name to key Fed leadership roles, and doesn’t want to risk rocking the boat before such a decision.
“We believe the Federal Reserve has not advanced a proposal to fix the SLR for political reasons,” said Jaret Seiberg, an analyst with Cowen Washington Research Group, in a research note. “This is because progressives in Congress are attacking any change that could be framed as reducing big bank capital.”
Key Democrats, including Senate Banking Committee Chair Sherrod Brown, D-Ohio, and Sen. Elizabeth Warren, D-Mass.,
Although senior Fed officials had said in March that any potential changes to the SLR would not diminish the strength of current bank capital requirements, Seiberg suggested that the central bank might still be worried about the optics.
“Treasury and Federal Reserve officials know that progressives will attack any change to capital requirements regardless of the merit,” he said. “We suspect they did not want this criticism to put at risk the ability of the president to nominate [Fed Chair] Jerome Powell to a second term.”
Still, time is of the essence, said Covas. If banks don’t have an incentive to intermediate in the Treasury markets, it could worsen any potential stress that might be around the corner.
“The cost of not doing anything is that it could exacerbate the volatility in yields in Treasury markets when the Fed starts tapering, or if we have another debacle around the debt ceiling” as Congress attempts once again to pass a measure to increase the borrowing limit, Covas said.
Kelly added that the Fed could avoid the political optics of adjusting the SLR just by issuing a request for public input on the issue, as it said it was planning to do in March.
“All they have to do is ask for comment. They don't even have to put out a policy,” he said. “The effort itself doesn't strike me as a divided issue; it's more the final conclusions that there might be some division.”
While the situation hasn’t reached the point where “we have a doomsday clock and it’s 11:55,” it’s also not going to resolve itself, said Campbell.
“I think we have gotten to a point where the leverage constraint is clearly more binding than it should be,” he said. “I think people generally agree that's not a good state of affairs. Given the projected path of the Fed balance sheet, asset purchases — that stuff is slowing down, but slowing down means still going up, so that means that the pain is going to continue for a while.”
