How will the Fed’s decision on the Supplementary Leverage Ratio (SLR) impact markets?
As banks look to do something with the amount of reserves, reducing deposits could be a likely approach, which would push assets into money market funds that invest in T-bills, depressing short-term yields.
Global Market Strategist
For better or for worse (after 2008, regulators likely always say for the better), banks are required to meet various liquidity and leverage requirements. One ratio that measures a bank’s ability to absorb losses is the Supplementary Leverage Ratio (SLR). The SLR formula measures tier 1 capital, which consists mostly of common and preferred stock, as a percent of total leverage exposure. Importantly, the total leverage exposure (denominator) is a broad measure of a banks risk weighted assets and includes a bank’s on- and off-balance sheet (such over-the-counter derivatives, repos, etc.) items, in which bank reserves and Treasury securities are included.
In April 2020, the Fed announced that it would temporarily exclude U.S. Treasuries and Fed deposits (bank reserves) from its calculation of banks’ SLR. This, all else equal, lowered banks total leverage exposure, therefore increasing their respective SLR and ability to take risk. This was an important step at the time; bank’s leverage exposure had been increasing rapidly as businesses and customers rushed into deposits and the FOMC had begun to rapidly increase the size of its balance sheet, causing a surge in bank reserves in the process. With the exemption in place, this lifted banks’ balance sheets constraints, allowing them to continue to hold Treasuries and provide liquidity to the market.
This exemption is set to expire on March 31, 2021. A concern markets have is if banks will be adequately capitalized once these assets are included back in the denominator of the SLR calculation. Indeed, current estimates suggest the re-inclusion of these assets would add ~$2.1 trillion USD of leverage exposure across eight GSIBs. At the same time, total bank leverage has continued to increase as the Fed continues its asset purchases of $120bn USD /month and the Treasury draws down the Treasury General Account (TGA) to partially fund the $1.9 trillion USD stimulus package and to reduce balances ahead of the debt ceiling.
With that said, should markets be concerned about this change from the Fed? In the short term, no. The U.S. regulatory minimum SLR for global systemically important banks (GSIBs) is 5%, however, U.S. GSIBs generally run an SLR north of 6% in order to be considered “well-capitalized”. As of the end of 2020, all GSIB SLRs excluding this regulatory relief were well above the 5% requirement, with most above the 6% “well-capitalized” threshold. However, as the TGA is drawn down from $1.1 trillion USD today to $500 billion USD by the end of 2Q21, and Fed purchases continue, without the extension a couple of GSIBs would start to push up against that 5% level by the end of the year.
By then, however, banks will have adjusted to the new regime as they have a few options to consider. Banks could:
- increase tier 1 capital (numerator) by issuing preferred or common stock,
- reduce their leverage exposure (denominator) by selling treasuries, decreasing deposits (pushing savers out of holding deposits and into money market funds) or,
- decrease their market making/repo activity (off-balance sheet activity).
As a result, bank demand for Treasuries could fall, putting upward pressure on yields. Moreover, as banks look to do something with the amount of reserves, reducing deposits could be a likely approach, which would push assets into money market funds that invest in T-bills, depressing short term yields.
Overall, we’re not too concerned about the Fed not extending the exemption at the end of the month. The Fed has even left the door open for a recalibration of the SLR altogether. As we move the year, however, we will be closely monitoring how banks adjust to stay within their regulatory requirements.
Reserve balances held at the Federal Reserve