Wall Street analysts and lobbyists are calling on the Federal Reserve to ease capital requirements to improve liquidity in the $24 trillion Treasury market as part of an ongoing overhaul of the rules governing the nation’s biggest banks.
The US government debt market is considered the safest in the world, in part because of the ease with which traders can buy and sell bonds. That liquidity, however, has deteriorated in recent years as banks have retreated from their traditional market roles. Bloomberg’s index, which measures liquidity in the Treasury market, hit its worst levels in late 2022 since the March 2020 market shock.
Banks have long argued that lowering their capital requirements by exempting treasuries and cash reserves from their so-called “supplementary leverage ratios” (SLR) calculations would allow them to participate more in the market.
A “comprehensive” overhaul of the banking system’s capital rules by the Federal Reserve’s new vice chairman for oversight, Michael Barr, offers the potential for such reform by 2023. Some experts warn that any relaxation in that direction is likely to be accompanied by: increasing capital requirements elsewhere, a solution unlikely to appeal to banks.
Mark Cabana, head of US interest rate strategy at Bank of America, said: “Any way regulators can stimulate demand will benefit the Treasury market. We don’t know if the SLR reform will come next year, but we would support it.”
After the spectacular collapse of the banking system during the 2008 financial crisis, regulators required lenders to hold more cash in case of another major downturn. The SLR requires large banks to hold capital equal to at least 3 percent of their assets, or 5 percent for the largest, systemically important institutions.
There is evidence that these rules have been effective; banks have weathered the Covid-19 crisis relatively unscathed. But the performance of the Treasury market has suffered as lenders have pulled back over the past decade, including during the March 2020 market crash, when high-speed traders who replaced banks since 2008 withdrew from market activity.
“With higher capital requirements, you have less balance sheet to allocate to marketing,” said Joseph Seidel, chief operating officer of securities industry group Sifma.
Greg Baer, executive director of the Banking Policy Institute, another lobbying group, echoed that sentiment. “The SLR has obviously been a conundrum for years. Every market participant and analyst seems to think so [change] would help market liquidity, some a lot, some a little, but none to zero.”
The argument is not just the banks and their lobbyists. Treasury market regulation and financial stability experts have warned of the consequences of neglecting the treasury market. “[SLR relief] questionably encourages or at least makes it easier for primary dealers to justify their capital to the Treasury market,” said Yesha Yadav, a professor at Vanderbilt Law School who studies Treasury market regulation.
Andrew Metrick, a Yale School of Management professor whose research focuses on financial stability, emphasized the risk-free nature of cash reserves and Treasuries. “Even if we’re going to have a leverage ratio, it seems to me that government bonds don’t really belong in any measure of bank riskiness.”
One key caveat, however, is that the Fed temporarily exempted reserves and Treasuries from the standard leverage ratio in the wake of the March 2020 crash, hoping to encourage banks to participate more in the market. The experiment was only a modest success. the changes in marketing activities and balance sheets were not drastic, and the exemptions caused considerable concern among progressive lawmakers.
During a congressional hearing in November, Barr, who took office in July, acknowledged growing volatility in the Treasury market and said the Fed was “vigilant” about liquidity concerns. However, he clarified that he does not expect adjustments to current capital requirements to have too much of an impact.
“If you ranked the list of reasons for liquidity constraints in the Treasury market right now, it’s probably relatively low on the list,” he told US lawmakers. The SLR is part of his broader overhaul, however, leading some to hope that changes may be on the way.
Gennady Goldberg, an interest rate analyst at TD Securities, says: Barr also said any changes to US law would need to be weighed against concerns about market liquidity. And the fact that was specifically mentioned gave me a little bit of hope that they might ease the SLR a bit to help improve market liquidity.”
What regulatory experts expect to garner potential support is exempting bank reserves held at the central bank from SLR calculations, an idea previously favored by Nellie Liang, who serves as the Treasury’s undersecretary for domestic finance.
“On the forward side, there probably won’t be as much of a fight for reserves because they’re really, really not a risk,” said Jeremy Kress, a former lawyer at the Fed’s banking regulation and policy group who is now at the university. From Michigan. “With Treasuries, you still have some balances [risk] that you might want to preserve capital.’
Any changes to the SLR are likely to be accompanied by tougher rules elsewhere. In remarks in early December, Barr noted that US capital requirements are “going to the low end of the range” that is generally considered optimal.
Ian Katz, a financial policy analyst at research firm Capital Alpha Partners, says: [Barr] won’t the banks like it?’
The lobby groups’ expectation is that the government will hold off on making any changes to bank capital until policymakers first address the implementation of the so-called Basel endgame rules. The new Basel rules set global minimum standards for bank capital requirements and are designed to make lenders more resilient in times of financial stress. Lobbyists hope plans to finalize the rules in the US could be released in the first six months of 2023.