The Hidden Bank Panic

Institutions are demanding the Fed exclude Treasuries from their leverage ratios - just as the BTFP expires and the CRE bank crisis begins to accelerate.

With the Bank Term Funding Program ending on March 11th, many institutions are panicking- to the point they are asking for relief from the Fed in their leverage ratios. Could this be a replay of the 2020 Financial Crisis?

In the depths of the COVID-19 crisis, the Fed announced a rule change to the vaunted SLR, allowing banks to deduct bank reserves (deposits held at the Fed) and Treasuries from the ratio. By lessening the constraints imposed by the SLR on major banks, the Fed was trying to encourage these institutions to increase the size of their balance sheets and continue lending to both large corporations and small businesses across the broader U.S. economy. 

A bank's capital represents the surplus of its assets over its liabilities. As a result, capital serves to mitigate the risk of a bank becoming insolvent, wherein its assets fall below its liabilities. Banks typically adhere to two types of capital requirements: risk-based and leverage ratios.

Risk-based requirements force banks to uphold a specific amount of capital, calculated by multiplying the bank's risk-weighted assets by a predetermined percentage. Risk-weighted assets are computed by multiplying each asset type by a weight that corresponds to the asset's risk level.

For instance, based on the current Basel III standardized approach, a commercial and industrial loan carries a weight of 100 percent, an agency MBS 20 percent, and a deposit at a Federal Reserve bank carries a weight of zero. Thus, risk-based capital requirements necessitate that a bank with riskier assets maintains more capital compared to a bank with less risky assets.

Compared to risk-based requirements, leverage requirements do not differentiate assets based on risk; all assets are assigned a risk weight of 1. Therefore, two banks with identical amounts of equity and assets possess the same leverage ratio and face the same requirement, irrespective of whether one bank's assets are considerably riskier than the other's.

In the US, banks report two leverage ratios. The tier 1 leverage ratio denotes the ratio of tier 1 capital (mainly common and preferred equity) to assets. On the other hand, the supplementary leverage ratio represents the ratio of tier 1 capital to total leverage exposure (assets plus estimates of off-balance sheet exposures).

I’ll include a quote from a prior piece, Stuffing the Coffers for reference- I highly recommend you read it;

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.