MNI INTERVIEW: Stein–Troubled Treasury Market Needs Reform

The Federal Reserve should relax banks’ supplemental leverage ratio as well as significantly expand eligibility for participation in its standing repo facility in order to ease the Treasury market’s liquidity troubles, former Fed governor Jeremy Stein told MNI.

Stein said well-intended rules that require banks to hold capital against their Treasury reserves have become an undue burden, making institutions reluctant market makers in times of stress.

“You want to defang the leverage ratio, you don’t want it to be the primary binding constraint,” said Stein, a member of the G30 Group of financiers and academics which recently released a report recommending key Treasury market reforms.

“That doesn’t mean weakening capital requirements. One way to defang it is simply to make the risk-based requirements higher. Our basic recommendation was some combination of dialing back the leverage ratio and at the same time strengthening the risk-based, so you don’t have any fewer dollars of capital in the banking system.”

Stein cautioned that none of the proposed reforms would be a panacea for a market that has simply gotten too large, but said there was plenty of room for making the system less prone to liquidity runs, the worst of which was seen during the March 2020 financial seizure associated with the start of Covid.

The USD22.5 trillion trade in Treasuries has become a victim of its own size as liquidity has begun to dry up more frequently than would be expected of the world’s deepest – and ostensibly most liquid – market.

“Due to some combination of initial miscalibration and, very importantly, all the reserves that have been pumped into the system, which tend to blow up the size of bank balance sheets, that has made this leverage ratio the relatively more binding constraint for many of the players,” Stein said.

“As a result, it’s very expensive for them to hold either Treasuries on their balance sheet or make repo loans against Treasuries – that makes them more reluctant to make markets. So when everybody else is dumping Treasuries and you hope the dealers are going to intermediate that, they’re going to do less of that or they’re going to lend less against Treasuries, and that’s a problem.”

While the Fed can exempt Treasury reserves from the calculation of the leverage ratio, and did so on an emergency basis in response to Covid, it could be politically thorny to make a more permanent change.

“The leverage ratio has become sort of a totem for a number of the folks on the progressive side of the aisle,” Stein said. We’re at pains to make the point that, you can be as tough as you want, you can be as much of a capital hawk as you want, we just urge it to be via the risk-based, not the leverage ratio.” (See: MNI INTERVIEW: Treasury Market Reforms To Ramp Up-Liang)

STANDING REPO FACILITY

Another essential reform in Stein’s view, in line with the G30 recommendations, is to expand the list of counterparties who can participate in the Fed’s Standing Repo Facility, currently reserved for primary dealers and depository institutions.

“We thought it was very important that it be available, with some qualifications, basically to anybody who can bring Treasuries to the Fed to pledge as collateral,” he said.

“If you think about March 2020, we had all kinds of nonbank players who were basically dashing for cash. They needed cash so they were dumping their Treasuries. If they knew with certainty ahead of time, anytime I have a Treasury I can go monetize it at the Fed, maybe they don’t preemptively run."

Stein pushed back against the notion that this would create a moral hazard, in particular because any move that makes Treasuries more valuable benefits taxpayers.

“Even if somehow does goad somebody into being a bit more aggressive about buying Treasuries with more leverage, who benefits? Treasury prices go up, yields go down – the taxpayer benefits,” he said. “So it’s very different to doing this against corporate bonds, where there would be a benefit to the corporate issuer and the taxpayer would be putting out something of value and not getting anything back.”