In April and May of 2020, bank regulators temporarily excluded US Treasuries and reserves held at the Federal Reserve from the calculation of the Supplementary Leverage Ratio (SLR) for the express purpose of improving market conditions in the U.S. Treasury market and increasing banks’ ability to provide credit to households and businesses. These temporary exclusions are set to expire all at once on March 31, 2021.
In this post, we argue that allowing the temporary modification to leverage requirements to expire all at once is problematic and risks undermining the goals that the temporary modification are intended to achieve. Consistent with our initial comment letter on the SLR rulemaking, we do not believe that tying the expiry of the exclusions to an arbitrary date is appropriate. Rather, the exclusions should be transitioned out gradually, in concert with all forms of official sector economic support as the economy improves. In particular, an abrupt change to leverage capital requirements would not comport with recent statements by Federal Reserve officials that now is not the time to be putting on the brakes on support to the economy. In addition, immediate expiry of the temporary modifications will further incentivize the growth of non-banks that have come under renewed scrutiny in light of recent market events during the pandemic.
The Supplementary Leverage Ratio: Implications for Market Functioning and Balance Sheet Growth
The Supplementary Leverage Ratio (SLR) is a risk-insensitive capital requirement that compares a bank’s equity to the value of its assets irrespective of the underlying risk of those assets. A bank that increases its holdings, including of low-risk assets such as U.S. Treasury securities or even cash, sees an increase in its required capital. Essentially, the SLR subjects all assets held by a bank to the same capital requirement regardless of its risk. This risk-blind feature of the SLR has a significant impact on a banks’ ability to hold and intermediate low-risk assets such as U.S. Treasuries. This economic insight is not purely academic. A wide array of empirical research has shown that the SLR has had a negative impact on the liquidity and functioning of U.S. Treasury markets. As a specific example, Darrell Duffie from Stanford University discusses, here and here, how the SLR has impaired the functioning of the U.S. Treasury market. Importantly, these findings were made during relatively benign economic conditions and are all the more relevant in the current environment.
Further, the SLR erodes a bank’s ability to accept deposits and grow its balance sheet in response to customer demand for safe deposits. As soon as a bank receives a deposit, it is subject to the SLR’s risk-blind capital requirement even if those deposits are invested in low-risk assets such as cash reserves or U.S. Treasuries. As a result, the inclusion of U.S. Treasuries and cash reserves in the SLR would impair a bank’s ability to service depositors, grow its balance sheet, and support the economy during the pandemic.
Temporary Modification of the Supplementary Leverage Ratio
In the early stages of the pandemic, two things occurred simultaneously. The liquidity and functioning of U.S. Treasury markets worsened considerably amid heightened, pandemic-induced volatility. According to research at the Federal Reserve Bank of New York, the cost of buying or selling a U.S. Treasury security increased by a factor of five in a matter of days. Relatedly, the demand for bank deposits increased dramatically as businesses and households sought safe, liquid and readily accessible deposits amid heightened uncertainty. More specifically, Financial Services Forum members saw their total deposit base increase by over $800 billion, or 13.2 percent, in the first quarter of 2020.
In light of both of these events, regulators temporarily modified the SLR by excluding holdings of cash reserves and U.S. Treasuries from the SLR calculation. All banks with significant holdings of cash reserves and U.S. Treasuries experienced an increase in their SLR, which made the leverage requirement less binding.
As we emphasized this summer, this temporary modification was an appropriate and sensible policy action that simultaneously improved the ability of banks to intermediate and support U.S. Treasury markets while also improving banks’ ability to accept deposits and deploy credit into the economy. By all accounts, the policy has been successful. Treasury markets have improved markedly while banks’ balance sheets have continued to grow as they deploy credit into the real economy.
A key problem with the modification, however, is its time-limited nature. Specifically, under the regulators’ rulemaking the exclusion for cash and U.S. Treasuries will automatically expire, in full, on March 31, 2021.
Removing Accommodation Too Soon and Too Abruptly is Risky and Not Well Coordinated
The abrupt expiration of the temporary exclusions on March 31, 2021, is problematic for three reasons.
First, this kind of abrupt change – without a transition period — to regulatory policy creates what is often referred to as a “cliff effect” because the policy change results in a stark change that is akin to driving over the edge of a cliff. In economics and most of life, abrupt policy changes often result in significant impacts that are difficult to forecast or control. Imagine what would happen if the speed limit on the highway changed from 65 to 15 mph over a few hundred feet. Also, to the extent that the modifications to the SLR improved economic conditions there is reason to believe that an immediate reversal of these modifications would have the opposite effect. While the U.S. economy is showing some signs of recovery, it is clearly too soon to abruptly remove this important economic support.
Second, the rate at which the economic support provided by the SLR modification is removed should be coordinated with the rest of the support that is being provided to the economy. One way of summarizing the scale and scope of support to the U.S. economy is to consider the size of the Federal Reserve’s balance sheet. The Federal Reserve’s balance sheet encompasses a broad array of information on various programs that are designed to support the U.S. economy such as emergency lending facilities as well as direct U.S. Treasury purchases. The evolution of the size of the Federal Reserve’s balance sheet over the past decade is depicted in Figure 1.
As can be seen in Figure 1, the official sector is providing an unprecedented amount of support to the U.S. economy as the Federal Reserve’s balance sheet grew from roughly $4 trillion to over $7 trillion over the course of 2020. It should also be noted that the growth of the Federal Reserve’s balance sheet during this pandemic far surpasses historical experience. Further, it is important to understand that as the Federal Reserve grows its balance sheet by purchasing assets, such as U.S. Treasuries, it injects cash reserves into the banking system that automatically increases total assets in the banking system. As a result, Federal Reserve balance sheet growth imparts direct pressure on the balance sheets and leverage ratios of banks so long as bank reserves are included in the calculation of the SLR.
Moreover, there is no indication that the support depicted in Figure 1 will be removed any time soon. To the contrary, Chair Jerome Powell recently indicated in a speech that “now is not the time to be talking about exit.” We wholeheartedly agree. In addition, the transition path for all economic support measures should be coordinated so as to maximize their benefit to households and businesses across the country.
Third, removing the temporary modifications to the SLR will increase incentives for financial market activities and deposits to flow outside the well-regulated banking system. In light of events during this pandemic, several official bodies have asked a number of important questions about the role played by less regulated non-banks during the pandemic and the implications for financial stability. Allowing the temporary exclusions for U.S. Treasuries and reserves to abruptly expire for the SLR will only further incentivize the growth of non-banks because tighter risk-insensitive capital requirements will limit the balance sheet expansion of large banks. In light of recent events and the associated inquiry, such a trend would present undue risk to the U.S. economy.
The temporary and modest modifications that were made to the SLR in the wake of the pandemic’s arrival in the U.S. was an important and necessary step by regulators to provide macroeconomic stability. These modifications should not be allowed to abruptly expire at the end of March 2021. Rather, regulators should consider transitioning the SLR accommodation in the full context of all the support that is being provided to the economy. An abrupt expiration of these modifications will likely put unnecessary pressure on U.S. Treasury markets and will also provide further headwinds against bank balance sheet expansion. At this point in time, it is critical that economic policy be fully aligned to maximize support to the economy. An abrupt increase in leverage capital requirements risks undermining the goals the temporary changes to the SLR were intended to achieve, and may further increase risk by pushing more activity into the non-bank financial system.