Extending the Supplemental Leverage Ratio is Essential to Main Street

SIFMA believes there is a definitive need to extend the interim final rule (IFR) for bank holding companies that provides a temporary exclusion of U.S. Treasury securities and deposits at the Federal Reserve Banks from the Supplementary Leverage Ratio (SLR).  As we noted in our recent comment letter to the Federal Reserve System, “banking organizations have played a pivotal role in market stability by extending credit, accepting deposits, and intermediating the capital markets throughout the cycle. The extension of the IFR is critical to the continued ability of banking organizations to continue accepting deposits and acting as intermediaries in the U.S. Treasury market.  Additionally, it is crucially important that the Federal Reserve communicate their intentions regarding the IFR in the very near future to prevent any unnecessary disruptions.”

Below we answer several questions on the IFR and the SLR to further illustrate its importance to the smooth functioning and stability of our markets.

Q:  What are leverage ratios?

A:  Leverage Ratios are risk agnostic capital requirements which are intended to compliment Risk Based Capital rules, acting as a backstop and ensure banks’ balance risk appetite with size. Generally, a leverage ratio is a measure of total capital to total assets plus select off balance sheet exposures depending on the leverage ratio requirement.  All U.S. banks and bank holding companies are subject to leverage ratio requirements. There are different leverage requirements based on the size and systemic importance of a bank, but all of the U.S. leverage ratios are higher than the Basel rules.

Q:  Why did the banking agencies issue an Interim Final Rule (IFR) which temporarily exempts U.S. Treasuries and deposits at the Federal Reserve from the SLR?

A:  The Federal Reserve and the other banking agencies[2] acknowledged in the preambles of the Interim Final Rules (IFR) that the combined U.S.  “… response to COVID-19 has notably increased the size of the Federal Reserve’s balance sheet and resulted in a large increase in the number of reserves in the banking system.” Moreover, the banking agencies acknowledged that during the dislocation “market participants have liquidated a high volume of assets and deposited the cash proceeds with banking organizations in recent weeks, further increasing the size of banking organizations’ balance sheets.”  Looking forward, the Federal Reserve stated their balance sheet “…will continue to expand in the near term, as asset purchases continue.” They also concluded rightfully that “The ability of institutions to hold certain assets, most notably deposits held at a Reserve Bank for a depository institution and Treasury securities, is essential to market functioning, financial intermediation, and funding market activity, particularly in periods of financial uncertainty.”

As we will illustrate below, all the factors that lead to the Agencies’ initial decision to exempt U.S. Treasury securities and deposits held at the Federal Reserve Banks not only continue today but are even more compelling given the enormity of the continued U.S. Government response (stimulus), expected U.S. Treasury issuance in 2021 and the Fed’s ongoing quantitative easing.

Q:  Why should the Fed extend the IFR?

A:  Extending the IFR is critical to the financial stability of the markets, households and the U.S. government. It will permit banks to absorb the swell of deposits from the retail and wholesale markets which have been prompted by the U.S. and the Federal Reserve’s response to the COVID 19 pandemic.  Moreover, it will provide much needed capacity for the largest primary dealers which are bank affiliated so that they may continue to participate substantially in the unprecedented large size offerings expected at future U.S. Treasury security auctions.

Q:  What happens if the IFR is not extended?

A:  Banks are capable of satisfying leverage ratio requirements should the temporary exemption be removed. However, given the enormity of U.S. government and Federal Reserve actions over the past year and what is expected this year, banks will need to be increasingly selective regarding growth and, in particular, the growth of deposits and U.S. Treasury Holdings. Practically, that means that banks will turn away deposits by charging customers for maintaining balances (aka negative rates). In U.S. Treasury auctions, firms may reduce bid size or require higher rates for larger bids. This will immediately impact the rates that the U.S. will pay for debt and hike the cost of financing the U.S. debt borne by taxpayers and, ultimately, all other borrowers because these rates materially impact the rate charged for all other borrowing. Moreover, the “price” of U.S. treasury funding is an important benchmark for pricing other products including those offered to consumers such as mortgage loans. The increase in US Treasury rates will bleed into the cost of credit for retail and corporate borrowers.

Q: Can smaller banks fulfill the role of the larger banks if their capacity is drastically limited?

A: Unfortunately, it is not reasonable to believe that smaller banks en masse could replace a larger bank’s role in the financial system. For example, smaller banks are not primary dealers and cannot participate in an initial offering of U.S. Treasury securities. Moreover, purchasing large numbers of U.S. Treasury securities may harm their asset liability management approaches and would prevent them potentially servicing their normal footprint. Similarly, deposits gathering is tied to client relationships both in the retail and corporate markets. It is unlikely that retail depositors would move to a community bank and more likely would pursuit a non-bank fintech alternative. It is also potentially harmful and costly for a community bank to operate client relationships outside of its geographic footprint.  Switching to the corporate side, these entity types require full scale large sized product offering which only one community bank offers. It is important to note that community banks are subject to the tier 1 leverage ratio. In fact, the impact of leverage ratios and the significant deposit inflow is also impacting smaller banks. In response to these developments the Federal Reserve recently provided additional time for community banks to meet the minimum community bank leverage ratio requirements. [3]

Q:  Are banks making money off the IFR?

A:  In fact, the opposite is true. Banks are awash in deposits with limited opportunities to transform these liabilities into earning assets. Banks use deposits to lend to households and corporations. Presently, there is a lack of significant loan demand from these groups to absorb these deposits. Moreover, we are in an extremely low interest rate environment so the spreads on permissible investments like U.S. Treasury securities and Agencies are negligible.

Q:  Is the banking system weaker if the IFR is extended?

A:  The exemption of these assets was strategically selected by the Federal Banking Agencies because they present no credit risk. In fact, when the banking agencies were developing the SLR, they initially sought to remove Federal Reserve deposits from the SLR. In the end, they decided to let reserves remain within the ratio. The agencies believed these deposits would be negligible as the Federal Reserve was working down its balance sheet and believed that deposits would as part of that process decline.

Q:  Doesn’t the banking industry want Federal Reserve Deposits and U.S. Treasuries removed from the SLR?

A:  It is true the banks have advocated for the removal of Fed deposits and U.S. Treasuries from the SLR during its construction. However, at this juncture, banks are advocating for the continuance of the exemption to ensure the banking system has the capacity to function effectively and assist in economic recovery.

Q:  Why do deposits grow during a crisis?

A:  During an unexpected crisis like the COVID 19 pandemic; corporations, businesses, and investors liquidate securities and other investment positions to increase liquidity. The proceeds of those sales are deposited into banks. Similarly, corporations may have concerns regarding the future availability of credit and will draw on committed lines or, conditions permitting, will issue bonds and notes to augment liquidity. Hereto these proceeds are generally placed into banks as deposits.

On a more macro scale, the Federal Reserve will look to stabilize the market by purchasing assets to ensure there is sufficient dollar liquidity. The Fed did this during the recent market dislocation through direct asset purchases and government programs that were set up under the Exchange Stabilization Act and the CARES Act. These actions whether they were purchases or temporary financing likely ended up back in a bank in the form of deposits.

The graph below depicts deposits across large domestic banks. You will note, the speed of deposit growth was greatest in that March/April period. However, as the same graph illustrates, deposits expansion has not relented and continues its upward trajectory.

From year end 2019 to month end February 2021, deposits at large domestic banks increased roughly 25%. As mentioned above, the speed of growth was fastest during the initial market dislocation, however deposits swelled 95% between month end April 2020 and month end February 2021. Since the markets had stabilized and most investors had returned to the capital markets by the end of April, we can attribute the deposit growth at large domestic banks to the Federal Reserve’s quantitative easing, U.S. Treasury issuance and the impact of stimulus. Given the outlook for the continuance of sizeable QE, the impact of recent and potent stimulus and the size of forward U.S. Treasury issuance, we are generally certain that large domestic bank deposits will continue to increase in 2021 and likely beyond unless firms take very deliberate actions to curtail growth.

Q:  What influences the size of the Federal Reserve’s balance sheet and how does that impact banking organizations?

A:  The Federal Reserve performs several roles in the U.S. economy.  However, we have focused on the actions most pertinent during this economic recovery because these activities have a meaningful impact on the Federal Reserve’s balance sheet. Moreover, the size of the Federal Reserve’s balance sheet has material implications on the banking system, which is evidenced by the extraordinary growth in excess reserves coinciding with the rapid and sizeable purchase of assets by the Federal Reserve. This is explained below in the Quantitative Easing (QE) and Reserves discussion

The graph below illustrates the impact of the Fed’s actions during the COVID 19 dislocation and the subsequent efforts to promote economic recovery. You will note the Fed’s balance sheet has almost doubled between year-end 2019 and month-end February 2021. To put that in perspective, the current balance sheet is more than three times larger than at year-end 2010 and close to 70% higher than the previous highwater mark in 2017.

Given the outlook for QE, expected growth in operational deposits and U.S. Treasury support, it is easy to envision the Fed’s balance sheet to top at least $10 trillion by the end of 2021.  Moreover, and importantly related to bank’s leverage ratios, the growth in the Fed’s balance sheet has direct implications on banks’ balance sheets particularly at the large banking organizations. This feedback loop, where the Fed’s balance sheet creates feedback loops which increase the size of banks’ balance sheet, is well documented and not unique to the COVID economic recovery.

Q: How does Quantitative Easing (QE) drive the size of the Federal Reserve Balance Sheet?

A: The Federal Reserve generally engages in QE to manage monetary policy through interest rates or, as is the case today, to stimulate the economy.  They do this by executing large scale asset purchases, usually of U.S. Treasury securities and to a lesser extent agency security, to inject cash into the economy. The premise is that this cash will lower credit costs and stimulate investment and economic expansion.

Early in the pandemic, the Fed executed significant direct asset purchases as part of its market stabilization actions. Since late last year, the Federal Reserve has been purchasing $120 billion of U.S. Treasury and agency securities monthly. While we support this economic response to the COVID-19 pandemic, the expansion is materially larger and grew faster than any prior QE in recent history and has meaningful implication on the financial system, particularly banks. As mentioned above, these actions increase the size of the Federal Reserve’s balance sheet and in turn the banking system.

The Fed’s 2021 asset purchases are expected to add at least $1.4 trillion to their balance sheet. As noted, numerous times in this paper, much of proceeds from the sale of assets to the Federal Reserve will end up in the banking system either absorbed by the banks or much more likely as deposits at banks. Thus, these seemingly Fed-only actions exacerbate the growth of firms’ balance sheets and in turn pressure their leverage ratios.

In February 2021, the Fed stated in its Monetary Policy Report[4]  that it expected to continue its $120 billion monthly purchases at the current rate “…until substantial further progress has been made toward its maximum-employment and price stability goals.”  It is likely these goals will not be achieved until sometime in 2022 at the earliest given their lofty nature. Consequently, there is no evidence that the feedback loop between the Fed asset purchases/balance sheet and firms’ deposit growth will be decoupled any time soon, placing even more pressure on the leverage ratios of banks.

Q: How are reserves balances linked to QE?

A: Reserves represent the funds which a bank deposits in its account at the Federal Reserve. Banks place funds in their Federal Reserve account because it is risk free and receives a nominal interest rate (0.10%).  Practically, banks maintain deposits at the Fed to facilitate funds through the wholesale markets for activities such as buying and selling U.S. Treasuries or repos.  However, in more normalized markets, firms would manage their excess reserves to a minimum over expected demand given opportunity costs of funding a higher returning asset. Since the market is awash in cash and loan demand is soft, firms are willing to leave significant funds in their account. To put this phenomenon in context, reserves at the Federal Reserve have increased nearly 85% since January 2020. Given the expectation for continued and sustained QE, it is likely reserves will continue to grow mirroring the Fed’s asset purchase program.

Q: How does the primary dealer community ensure the success of U.S. Treasury auctions?

A: The Federal Reserve executes U.S. Treasury auctions through a community of primary dealers which act as market markers for treasuries. Primary dealers are critical to successful auctions as they set Treasury rates through a competitive bidding process. At the initial offer, primary dealers purchase much of the U.S. Treasury securities and then sell these securities into the market. Therefore, their capacity to purchase large amounts of U.S. Treasuries is critical to price and size efficiency of U.S. government funding. Today, the overwhelming majority of and the largest primary dealers are bank owned and subject to the leverage ratio regime. To date, the IFR’s exclusion of U.S. Treasury securities removed a potential impediment that might otherwise impair primary dealers’ market-making capacity, and in turn, the efficiency of the U.S. Treasury markets.

This is critical because current projections for 2021 U.S. Treasury security issuance are approximately $2.8 trillion (using current deficit projections) with the Federal Reserve likely absorbing close to $1 trillion of total issuance. As such, the market will need to absorb $1.8 trillion in U.S. Treasury securities. To date, the sum of 2020 U.S. Treasury issuance has yet to be fully absorbed as evidenced by the elevated holdings of U.S. Treasury securities across the banking system and in particular at the primary dealers. The most recent H.8 release noted that U.S. Treasury holdings increased over 173% since year-end 2019. It is critical that IFR relief is extended so that banking organizations retain the utmost capacity to purchase and manage this unprecedented issuance size.

Most recently, a U.S. Treasury auction for 7-year securities was widely noted as one of the weakest in recent history with lower-than-expected participation causing a bit of a stir in the markets. The auction results noted higher than expected rates and lower bid-to-cover ratios. This suggests that primary dealers may already be considering how to maintain leverage ratio flexibility.

Q:  How does the economy impact leverage ratios?

A:  During most economic times, leverage ratios act as backstops to risk assumptions. However, today, due to significant quantitative easing, the considerable size of economic stimulus injected into the economy and the sizable U.S. Treasury issuance, leverage ratios are under considerable pressure and have become a binding constraint on the ability of banks to expand their holding of these and other assets.

[2] There were two separate Interim Final Rules exempting U.S. Treasuries and deposits at Federal Reserve Banks from the SLR. The first was issued by the Federal Reserve regarding the BHC SLR and the later was issued by the Federal Banking agencies exempting the same assets from the bank’s SLR.

[3] https://www.federalregister.gov/documents/2020/04/23/2020-07449/regulatory-capital-rule-temporary-changes-to-the-community-bank-leverage-ratio-framework

[4] https://www.federalreserve.gov/monetarypolicy/files/20210219_mprfullreport.pdf

Coryann Stefansson is a managing director and head of prudential capital & liquidity policy at SIFMA