Stuffing the Coffers

The Fed has tied the banks and the Treasury together in a suicide pact that could spell disaster...

Regulatory changes made post-2008 have pushed banks and financial institutions to hold more and more Treasuries as part of their collateral. But they are running out of space… and time.

In early 2020, news of the burgeoning COVID-19 virus emerged, sending markets into a frenzy. This turmoil worsened as the Dow Jones Industrial Average witnessed its most significant single-day decline since the 2008 global financial crisis in mid- March, and bond market liquidity began to dry up as hedge funds, family offices, and other players began rushing to cash. To save the day, the Fed and other government agencies rode in and implemented drastic measures to stabilize both financial markets and the overall economy.

One of these measures was an exemption of Treasury bonds from the SLR, allowing banks to increase lending without worries of a fall in government bond prices. 

But why?

For some background, following the 2008 financial crisis, the Supplementary Leverage Ratio (SLR) was introduced as part of the Basel III reforms. The numerator of the ratio consists of tier 1 capital, while the denominator encompasses all on-balance-sheet assets, including U.S. Treasuries and deposits at Federal Reserve Banks, along with some off-balance-sheet items and derivative exposures. Unlike some risk-based capital ratios, the SLR does not assign risk weights to items in the denominator. Banks falling under Category I-III are mandated to maintain an SLR of 3%, and Global Systemically Important Banks (G-SIBs) are additionally subjected to a 2% enhanced SLR buffer for a total of 5%. Only institutions with $250B in assets or more are subject to the SLR.

As part of their initiatives to save a financial system in crisis, on April 1, 2020 the Fed introduced an interim rule valid until March 31, 2021 to exempt U.S. Treasuries and deposits at Federal Reserve Banks from the SLR calculation. The stated goal was to “alleviate pressures in the Treasury market caused by the coronavirus and increase the capacity of banking organizations to extend credit to households and businesses”.

U.S. banking institutions have historically adhered to what is known as a leverage capital requirement, determined by the ratio of Tier 1 capital to the average total consolidated on-balance sheet assets, known as the U.S. leverage ratio. However, the SLR considers both on-balance sheet and specific off-balance sheet assets and exposures. The Basel Committee introduced SLR in 2010, and its finalization occurred in January 2014. Treasuries were also listed as HQLA, High Quality Liquid Asset, which allowed them to be included in the LCR, the Liquidity Coverage Ratio and thus increased systemic bank demand for them. 

(Formed in 1974 by central bank governors of the G10 nations, the Basel Committee on Banking Supervision (BCBS) is a group of financial authorities. The Basel Accords encompass banking supervision recommendations, including Basel I, Basel II, and Basel III, issued by the BCBS. These accords derive their name from the BCBS having its secretariat at the Bank for International Settlements (BIS) in Basel, Switzerland, where the committee typically convenes. Link for more info here.)

In plain english, the SLR serves to calculate a bank’s ability to withstand losses to its assets. The Tier 1 Capital is common equity and retained earnings, which is divided against assets and derivatives exposure. If it has positive equity versus assets, this is one signal of solvency as the accounting equation A=L+E shows that positive equity relative to assets means that liabilities by definition are less than assets. If it has say 10% equity in relation to assets, that means the bank can withstand significant losses before running into trouble with regulators or other market participants, since it has overcollateralized its equity. 

So why did the Fed adjust the SLR rule during COVID?