MNI EXCLUSIVE: Fed Faces Battle To Ease Banks' Leverage Rules

The Federal Reserve's forthcoming proposal to retool the supplementary leverage ratio for big banks awash in reserves is seen as a pragmatic move for Treasury market liquidity but faces an uphill political battle, according to interviews with lawmakers, former officials and industry sources.

The Fed is expected to propose making permanent some or all of the temporary relief that expired last month, potentially with countervailing increases in the overall ratio, or lower the ratio altogether, sources said. The stakes are high with Fitch Ratings estimating USD3 trillion of deposits were added last year to the balance sheets of the largest U.S. banks in response to the Fed's stimulus actions, putting banks' SLRs on trajectory to fall close to the 5% minimum required.

Proponents of SLR relief argue the crude measure of capital adequacy was never meant to play a starring role in ensuring a sound banking system and penalizes lenders for the Fed's emergency stimulus. Banks will need to either shed assets or raise more capital to meet the full SLR requirement, and would be unwilling to hold Treasuries or lend against sovereign debt, with potentially disastrous consequences for financial market functioning, they say.

Others disagree, citing the need to strengthen regulation amid frothy markets. "I don't buy for a minute that bank capital rules are responsible for volatility in the Treasury market," former FDIC chair Sheila Bair told MNI. "As long as the Fed wants to continue these aggressive monetary policies, one would hope they would use their supervisory and regulatory authorities to tame the instability that monetary policy is causing."

OPTIONS ON THE TABLE

Democratic Senator Elizabeth Warren and Senate Banking Committee Chairman Sherrod Brown have called on regulators to restore the SLR as quickly as possible, and last week Warren told MNI it's still a work in progress. "There are a lot of moving parts on how the overall approach might be adjusted, both to deal with the fluctuations of the pandemic, but also to address the differences in how the largest financial institutions are changing their own asset ratios," Warren said.

The top Republican on the Senate Banking Committee, Patrick Toomey, told MNI that excluding reserves and Treasuries from the SLR ratio is on the table, but adjusting the ratio itself "might be a better way to deal with it."

The interim SLR relief could resurface as an option in the Fed's proposal for a permanent fix, sources said. An alternative to exclude only reserves from the calculation would be more palatable to regulators and lawmakers worried about sliding down a slippery slope of excluding marginally more risky assets. That could be accompanied by a slightly higher SLR ratio to keep capital requirements high.

COMPENSATING MOVES

"I'm not a fan of the leverage ratio playing a big role because it's completely risk-insensitive," Jeremy Stein, a Harvard professor who was a Fed governor when the SLR was adopted, told MNI. "You don't want it to be the dominant thing driving capital. However, given it's binding for some firms, you could just relax it."

But if the ratio is lowered wholesale, "you'd want to make some offsetting change to make banks hold more dollars in capital," such as raising risk-based capital requirements, he said.

A 2018 proposal to rejig the SLR, approved 2-1 by the Fed Board of Governors but never finalized, would lower the minimum ratio to 3% plus a risk-dependent surcharge ranging from 0.75% to 1.75% for each of the eight large U.S. banks.

That idea would support banks in their role as market makers and "lets the leverage ratio continue to remain a backstop as opposed to a binding requirement," said Francisco Covas, former Fed Board economist now head of research at the Bank Policy Institute, a trade group representing large banks.

Money market rates have been surprisingly stable since the SLR exemption expired last month as banks await the new proposal. "One reason could be that Fed is proposing a long term fix and that incentivizes firms not to make large adjustments to their balance sheets," Covas said.