Earlier this month, the US Office of Information and Regulatory Affairs published an oblique notice on its website stating that it had received a new rule proposal from the Federal Deposit Insurance Corporation.
If that seems a little dull, consider that the proposed rule’s title was even more mind-numbing: “Modifications to Supplementary Leverage Capital Requirements for Large Banking Organizations; Total Loss-Absorbing Capacity Requirements for US Global Systemically Important Bank Holding Companies.”
And yet, in some corners of the US finance industry, this has probably been greeted with the equivalent of a Mexican (soon to be rebranded American by the Trump administration, we assume) wave.
People in and around the Trump orbit have long talked about overhauling the “Supplementary Leverage Ratio” — one of the most controversial aspects of the post-2008 financial reform package — and the OIRA notice was firm confirmation that this is now coming, and probably coming soon.
This would be a fairly big deal. Earlier this year Barclays estimated that scrapping the SLR entirely could free up $6tn of lending capacity in US banks. Even a modest reduction would spur banks to buy as much as $500bn of Treasuries, pushing yields down and buoying markets more broadly, according to Eurizon SLJ’s Stephen Jen:
. . . A prospective relaxation of the SLR could lead to a strong demand for government bonds and an improvement in the liquidity of this market. Lower bond yields should be supportive of risk assets, negative for the dollar, and could buy more time for the US to deal with its fiscal challenges.
Importantly, recalibrating the SLR was motivated by the current Administration’s recognition that interest rates are now more important than equity prices, which in turn is an implicit admission that debt is now a genuine concern.
So, for readers lucky enough not to have to think about financial regulation, what exactly is the SLR, why has it become such a flash point, and would ending or reforming it really have such a magical effect?
The supplementary what?
The SLR is the American gold-plating of an important aspect of the international Basel III regulatory framework, which introduced a deliberately blunt “leverage ratio” charge for banks, compelling them to hold capital of 3 per cent of their overall assets, on top of myriad other capital requirements.
By “deliberately blunt”, we mean it intentionally treated German Bunds and US Treasuries the same as junk bonds and subprime mortgages. The point was to have an extra, easy-to-calculate and hard-to-game buffer of capital on top of the normal risk-weighted capital requirements.
However, the US went a step further and introduced the SLR, which required its biggest, most systemically important banks to have extra capital equal to 5 per cent of assets, rather than the Basel-stipulated 3 per cent.
You can probably understand why the big US banks dislike the SLR. But some more neutral parties have also raised concerns about its unintended consequences.
Because super-safe but low-yielding stuff like Treasuries require the same amount of capital set aside as a loan to a dodgy widgetmaker in Whynot, North Carolina, US banks are arguably disincentivised by the SLR to hold their own country’s debts.
This is one of the reasons why the Trump administration is so keen to overhaul the SLR: at a time when many foreign investors seem a bit leerier about holding oodles of Treasuries, it would be helpful to encourage domestic banks to fill the breach.
However, there are also financial stability concerns at play. While the SLR makes the banking industry safer, it could arguably come at a cost to the resilience of the broader financial system.
By disincentivising banks from absorbing some of the selling pressure, the SLR can be particularly troublesome when there is a sudden surge of financial volatility. Even regulators tacitly acknowledged this when they temporarily exempted Treasuries from SLR calculations during Covid, to ease the alarming bout of illiquidity the US government bond market suffered in March 2020.
On JPMorgan’s first quarter conference call, Jamie Dimon argued that an SLR overhaul “isn’t about relief to the banks; it’s relief to the markets”:
JPMorgan will be fine with or without an SLR change. The reason to change some of these things is so the big market makers could intermediate more in the markets. If they do, spreads will come in, there’ll be more active traders. If they don’t, the Fed will have to intermediate. I think it’s just a bad policy idea that every time there’s a kerfuffle in the markets, the Fed has to come in and intermediate. So they should make these changes.
Some caveats are in order. Obviously JPMorgan would benefit from the SLR being scrapped or diluted. Moreover, the Silicon Valley Bank debacle showed how even Treasuries can cause problems when your risk management approach is otherwise . . . cavalier. Lastly, Alphaville remains sceptical that banks, if they were just freed from some of those pesky capital requirements, would heroically throw their balance sheets on financial grenades.
Nonetheless, there’s a reason why a lot of sensible people have long agreed that the SLR could do with revisiting. The resilience of the Treasury market in particular is of such paramount importance that it would arguably be worth sacrificing a smidgen of bank regulations to buttress the financial system more broadly.
There have been a lot of suggestions on what could be done with the SLR, but they range from the radical — such as scrapping the extra charge altogether — to the more modest, by permanently exempting reserves and/or Treasuries from its calculation, or replacing the SLR with a risk-adjusted but higher capital requirement.
‘We see scope for SLR disappointment’
Unfortunately, some caution is necessary. Although the OIRA notice indicates that some kind of SLR tweak is in the works, it might not prove quite as seismic as proponents are hoping.
As Bank Reg Blog noted, the title of the proposed rule submitted for review at OIRA is very similar to one proposed by the Federal Reserve and the OCC back in 2018. However, this mostly just tweaked how the SLR would be estimated — leading only to a tiny $400mn estimated reduction in aggregate capital — and, crucially, didn’t exempt Treasuries from the calculation.
As a result, Bank of America’s analysts “see scope for SLR disappointment”, with some technical explanations for why:
Judging by the title of the FDIC proposal, we expect the FDIC proposal to look very similar to what the Fed + Treasury + OCC proposed in 2018 for GSIB eSLR and TLAC. We continue to believe lowering eSLR will not increase bank demand for USTs, given that banks already freely swap from reserves to USTs without generating SLR capital consumption. We also believe that lowering eSLR will not increase dealer capacity to hold or fund USTs. For regulatory capital, the Holdcos today are effectively “overcapitalizing” their dealer subs to cover the bank subs’ capital needs. This means that total demand for USTs is not likely to increase for dealers or the GSIBs on a lower eSLR.
(To clarify, “eSLR” here refers to the US’ enhanced SLR requirement for the biggest banks, above and beyond what Basel III calls for).
Secondly, it’s far from clear that even a more radical overhaul would have the impact that some have touted.
The SLR ratios of the four biggest US banks have held steady at north of 6 per cent for the past few years, even as the volume of their outstanding preferred stock — the cheapest form of “tier 1” capital — has been falling. As JPMorgan’s analysts have noted:
This suggests that the SLR constraint is easily being satisfied by more junior (and more expensive) forms of capital, which is only optimal if it is necessary in order to meet some other capital requirement. In other words, a stable SLR together with falling preferred stock outstandings is indicative of the fact that SLR is not a binding constraint for these top 4 banks in aggregate.
Thirdly, this could still take a loooooooooong time to happen. Despite the OIRA notice, the reality of US rulemaking is a bit like watching Man Utd play: soul-crushingly grim, unremittingly tedious, unbelievably messy, and by the end of it you’ll wish everyone involved had suffered an injury.
Michelle Bowman has now been confirmed as the Federal Reserve’s new vice chair for bank supervision, but Jonathan Gould is still waiting for the Senate to confirm him as head of the Office of the Comptroller of the Currency, and the Trump administration has yet to nominate anyone to lead the Federal Deposit Insurance Corporation. They will probably need to be in place for a new SLR rule to move forward.
Even when it does, the new rule will need to be made public in the Federal Register and opened up for an extended comment period. Then all the comments are reviewed — and there will be many for a high-profile issue like this — before the relevant regulators formulate a final rule. And that final rule is then subject to an often extensive implementation period.
In other words, all those swap spread trades could be languishing in financial purgatory for some time.
