In a move that’s sure to transform every pedestrian market observer into some combination of a rates strategist and a regulatory crusader, the Fed on Wednesday afternoon decided to “temporarily” exclude Treasurys and deposits at Federal Reserve banks from the supplementary leverage ratio.
The idea, basically, is to ensure that the behavior of market participants in light of recent turmoil and the effects of the policy actions taken to ameliorate that same turmoil don’t end up curtailing banks’ capacity to intermediate and lend.
So, for example, the Fed’s balance sheet has obviously ballooned, precipitating a jump in reserves. On top of that, market participants have been selling everything that isn’t tied down to raise cash which is then deposited, ultimately swelling banks’ balance sheets too.
As the Fed patiently explains, “absent any adjustments, the resulting increase in the size of banking organizations’ balance sheets may cause a sudden and significant increase in the regulatory capital needed to meet a holding company’s supplementary leverage ratio requirement”.
Well, some of the affected entities are primary dealers, of course, and colloquially speaking, you don’t want to end up tripping over your own feet by constraining their capacity to facilitate market functioning and extend credit, an outcome the Fed is clearly concerned about and trying to mitigate with this interim rule.
As you may recall, the Treasury market – traditionally the most liquid, deep market on the planet – effectively “broke” in March (more here and here), and liquidity has been severely impaired. Here’s a bit more from the Fed:
In particular, liquidity conditions in the Treasury market have deteriorated in past weeks, evidenced by widening bid-ask spreads that remain elevated despite increased open market operations by the Federal Reserve. Large holding companies have cited balance sheet constraints for their broker-dealer subsidiaries as an obstacle to supporting the Treasury market. Specifically, the supplementary leverage ratio can limit holding companies’ ability to own Treasuries outright as well as to increase deposits at the Federal Reserve Banks.
So, if you exclude Treaurys and deposits, you effectively up the leverage exposure capacity for these banks.
If your next question is “By how much?”, the Fed has a number for you. To wit:
In light of the proposed exclusions under this rule, this temporary reduction in capital requirements is expected to increase leverage exposure capacity at holding companies by around $1.6 trillion. In particular, the Board expects that the increase in leverage exposure capacity will facilitate intermediation by broker-dealer subsidiaries of bank holding companies and therefore increase liquidity in stressed financial markets. Similarly, the Board expects that the increase in leverage exposure capacity will facilitate increases in customer deposits at banking organizations subject to the interim final rule, and therefore ensure that these banking organizations remain able to fulfill this important function.
The Fed cites “unprecedented economic distress” in the decision and says this latest effort to “fix” what’s broken will both enhance market liquidity and boost banks’ capacity to lend.
If it does nothing else, it will at least make banks more likely to participate in repo and make markets in Treasurys. Simply put, participating in those activities is now cheaper.
Bonds obviously liked this, and 10-year yields fell 4bps in the knee-jerk reaction to the press release, flattening the 2s10s to the day tights in the process. This should put a little pep in the step of Treasury futures in Asia on Thursday.
As alluded to here at the outset, this move will probably be jeered by at least some critics, if not for the inevitable increase in overall banking system leverage it will precipitate, then for the extent to which it might be construed as helping facilitate deficit financing.
If you know where to look, it didn’t take long to source a couple of snappy soundbites.
“One up day in the VIX later, one must wonder how ‘temporary’ it will prove to be”, Danielle DiMartino Booth remarked. Jim Bianco, meanwhile, quoted Jean-Claude Juncker: “When it becomes serious, you have to lie”.
I’ll leave you with the Fed’s take on why this is generally going to be a riskless endeavor.
The exclusion of Treasuries and deposits at Federal Reserve Banks will help alleviate ongoing stresses on the financial system and the real economy arising from COVID-19. As Treasuries and deposits at Federal Reserve banks are free of credit risk, their exclusion will also not incentivize risk-taking by banking organizations. The Board will closely monitor the balance sheets of banking organizations subject to the interim final rule in the coming months with a particular view toward any resulting increase in risks. In addition, the tier 1 leverage ratio will continue to act as a backstop for all bank holding companies and savings and loan holding companies subject to the capital rule.