A Federal Reserve announcement provides temporary relief to banks on leverage and capital adequacy
A new rule on calculating the supplementary leverage ratio—a capital adequacy measure—allows expanded balance sheets and potentially greater expansion of quantitative easing
- The Federal Reserve announced a new rule that temporarily excludes U.S. Treasuries and deposits with Federal Reserve banks, from its calculation of the supplementary leverage ratio or SLR, a measure of banks’ capital adequacy.
- Relaxing this calculation will allow banks to temporarily expand their balance sheets, which should help facilitate the flow of risk and liquidity through the banking system.
- Banks will likely use the relief to buy more Treasuries and agency mortgage-backed securities and sell them into the Fed’s quantitative easing program.
- The implications for liquidity investors include possibly further flattening the interest rate curve towards zero and tightening mortgage spreads; we will need more time to determine any direct effects on the credit market.
The Federal Reserve (Fed) announced on April 1, 2020 that it would temporarily exclude U.S. Treasuries (USTs) and banks’ deposits with the Fed (Fed deposits) from its calculation of banks’ supplementary leverage ratio or SLR. The action is the latest aggressive measure by the Fed to help ensure the flow of risk and liquidity through the financial system. It is set to last until March 31, 2021. Below are some frequently asked questions relevant to liquidity investors about the new rule.
The Fed has temporarily excluded USTs and Fed deposits from its calculation of a bank’s SLR. What is the SLR?
The SLR is measure of capital adequacy. Essentially, it measures in percentage terms a bank’s ability to take losses on its assets. The formula is SLR = (tier 1 capital)/(total leverage exposure). This change reduces the denominator in the SLR calculation and as a result temporarily increases banks’ SLR. With more capacity in the SLR, it should increase banks’ ability to take risk.
What is tier 1 capital?
Tier 1 capital is a bank’s immediately available capital that gives it the capacity to absorb losses. It is primarily made up of common stock, retained earnings and certain kinds of preferred stock.
What is the total leverage exposure?
The total leverage exposure is the combination of a bank’s on-balance sheet and off-balance sheet (not directly owned) assets. This part of the calculation temporarily excludes USTs and Fed deposits.
Is there a minimum SLR?
For banks with greater than USD250 billion in assets, or USD10 billion in on-balance sheet foreign exposure, the minimum SLR is 3%. However, the minimum SLR is 5% for institutions banking supervisory bodies consider “global systemically important banks” (GSIB). If a GSIB’s SLR is below 5%, the Fed will put restrictions on its ability to make capital distributions to equity shareholders, and restrict discretionary bonuses to bank employees. In order to be considered “well capitalized,” a GSIB must have an SLR of 6% or greater.
What will banks do differently, given this relief on the SLR calculation?
Over time, banks will likely buy more USTs and sell them into the Fed’s quantitative easing (QE) program. Banks will likely also use this relief to buy more agency MBS to sell into the Fed’s QE program.
Why do banks need this change, permitting them to enlarge their balance sheets—if a bank sells a UST into the Fed’s QE program, wouldn’t that sale shrink its balance sheet?
Not exactly. When the Fed buys an asset from a bank through its QE program, the Fed pays for the asset by crediting the bank with a Fed deposit. So technically the bank’s balance sheet does not shrink in a QE transaction with the Fed. The bank just exchanges one asset, a UST, for another, a Fed deposit, on the asset side of its balance sheet. That’s why if the Fed wants to continue to increase its QE program, it needs to grant this relief. Put another way, for the Fed’s QE purchases to potentially accelerate in the future, the Fed needs banks to have assets it can purchase. So banks need the ability to hold more assets in the first place.
Are bank balance sheets increasing for reasons other than QE transactions with the Fed?
Yes. And this helps explain another reason why we need the new SLR rule. Banks have been receiving significant inflows of customer deposits as a result of the current period of volatility. Banks can do a number of things with those deposits, including making loans or underwriting mortgages, but the most conservative thing a bank can do with the cash from the new customer deposit is to buy USTs or make a Fed deposit. Without the SLR relief, doing those things would increase the denominator in the SLR calculation and therefore lower the SLR. By omitting USTs and Fed deposits from the SLR calculation with this change, the Fed increases the banking system’s ability to take on more customer deposits.
Will the banks use this relief to buy or originate more risk assets?
It is not immediately clear whether banks will use the relief to take on a significant volume of credit assets. The Fed would definitely encourage bank balance sheet expansion to funnel more USTs and agency MBS into the QE program. The Fed would probably welcome increasing lending to small businesses and refinancing more residential mortgages. Theoretically, the broker-dealer community, which may have been facing balance sheet constraints before the announcement, could use this relief to ramp up its usage of the Primary Dealer Credit Facility (PDCF, outlined here). But it is not clear at this time if regulatory relief for the PDCF is one of the aims of the change to the SLR calculation.
Does this rule address all the constraints on banks’ ability to take risk?
No. The SLR is only one of the constraints on the banking system’s ability to take risk. This announcement does not address all the others. (For example, banks may be limited by stress test limits as a part of their Comprehensive Capital Analysis and Review). However, it was a constraint in maintaining orderly UST markets. If there are other regulatory constraints on maintaining orderly UST markets, we believe the Fed will do what it takes to address them.
What are the implications for liquidity investors?
The Fed’s QE purchases of USTs should continue to ramp up and, eventually, further flatten the interest rate curve towards zero. For those front-end portfolios that invest in mortgages, we should also eventually see mortgage spreads tighten. We will need a little more time to determine if there are any direct effects on the credit market.
For additional questions, please contact your J.P. Morgan Global Liquidity Client Advisor.
1 For more information, see Kyongsoo Noh, “The Federal Reserve keeps at it: New supportive actions this week,” J.P. Morgan Global Liquidity, March 25, 2020.
2 According to the Federal Reserve, the primary function of capital adequacy “is to support the bank's operations, act as a cushion to absorb unanticipated losses and declines in asset values that could otherwise cause a bank to fail, and provide protection to uninsured depositors and debt holders in the event of liquidation.”
3 Kyongsoo Noh, “Making monetary policy: The Federal Reserve moves in the right direction,” J.P. Morgan Global Liquidity, March 19, 2020.