Bloomberg News
The Federal Reserve’s prime regulator stated modifications are wanted to the supplementary leverage ratio to enhance the Treasury market and guarantee banks face correct threat incentives.
In a Monday speech, Fed Vice Chair for Supervision Michelle Bowman stated the present calibration of the capital requirement is holding some banks again from facilitating Treasury securities transactions. She stated modifications are wanted to make sure the SLR will not be binding for the biggest banks within the nation.
“Leverage ratio impacts on bank-affiliated broker-dealers can have broader impacts, together with market impacts like these noticed in Treasury market intermediation actions,” Bowman stated. “Once we have recognized ‘rising’ unintended penalties — points that weren’t contemplated through the growth of a regulatory method — we should take into account revisit earlier regulatory and coverage choices.”
Bowman’s remarks, delivered at a analysis convention in Prague, come simply days earlier than the Fed is poised to formally take up the matter of SLR reform. The Fed board of governors will unveil potential modifications to the regulatory framework throughout an open assembly on Wednesday.
Like different regulatory officers, Bowman stated the fast growth of Treasuries and central financial institution reserves lately have flooded financial institution steadiness sheets with low-risk belongings, inflicting the risk-blind SLR to turn out to be extra capital-restrictive than different, risk-adjusted regulatory mechanisms.
Bowman stated this dynamic has brought about bank-affiliated major sellers within the Treasury market to drag again on intermediation, which has in flip contributed to the dwindling liquidity in that market. She pointed to the 2019 stress within the repurchase settlement, or repo, market, the so-called “sprint for money” in 2020 and even steadiness sheet pressures that arose this previous spring throughout heightened Treasury market volatility as indicators of accelerating fragility.
Bowman acknowledged that elevated debt issuance, saturation and rate of interest volatility have additionally contributed to the problems going through the Treasury market, however added that regulators have an obligation to alleviate any unneeded stress that they will.
“Due to the position of huge banks within the intermediation of Treasury markets, there’s a direct hyperlink between banking regulation and Treasury market liquidity,” she stated. “Particularly on the subject of the expansion of ‘protected’ belongings within the banking system and the rise in leverage-based capital necessities changing into the binding capital constraint on some giant banks.”
Introduced in 2014, the SLR was supposed to be a “backstop” for the regulatory framework, making a 3% — or 5% for the biggest banks — capital ratio behind a extra sturdy, risk-based construction. Under the risk-weighted method, Treasuries are assigned a zero weight, whereas company loans are sometimes set at near 100%.
But, as some banks — significantly these with giant buying and selling books — load up on low-risk belongings, the SLR minimal is more and more calling for a bigger capital requirement than the risk-weighted minimal. Indeed, a handful of huge banks are persistently sure by the SLR whereas a couple of others are restricted by it periodically.
When the SLR first went into impact, risk-weighted belongings accounted for 48% of leverage publicity on the steadiness sheets of the eight largest, world systemically essential banks. That ratio has since come right down to 40%, which Bowman stated is proof that the backstop requirement has turn out to be the first capital constraint that giant banks need to handle.
“This downward pattern ends in the SLR more and more changing into the binding constraint and displays banks’ rising holdings of high-quality liquid belongings, most of which carry a threat weight of zero below risk-based capital ratios however have a 100% weighting below leverage capital ratios,” she stated.
Despite this gravitation towards low-risk belongings, Bowman warned {that a} banking system primarily ruled by a risk-blind leverage ratio might incentivize extreme risk-taking by banks, since there isn’t any capital premium for riskier exposures and no low cost for safer ones.
“A binding leverage capital requirement can create perverse incentives for banks to shift their steadiness sheets into increased threat belongings, since doing so might generate bigger returns with out requiring extra capital,” she stated. “This is just a trigger and impact of overly restrictive leverage capital.”
Yet, even for banks sure by the SLR, risk-weighed capital requirements nonetheless apply, which means a rise in riskier exercise might end in still-higher capital necessities.
Bowman stated the purpose of this week’s assembly is to handle the present calibration points with the SLR, noting that the regulators are lastly delivering on reform first referred to as for in 2021, after the non permanent exemption of Treasuries and reserves from the ratio’s calculation amid the COVID-19 pandemic.
“The proposal would solicit public touch upon the impacts of this miscalibration, potential fixes, and work to develop an acceptable and efficient answer,” she stated. “This proposal takes a primary step towards what I view as a protracted overdue follow-up to assessment and reform what have turn out to be distorted capital necessities.”
