Ending leverage ratio relief could force US banks to downsize

Biggest lenders may have to limit repo activity to manage leverage capital, observers say

Locked-up capital

The removal of a carve-out of US Treasuries and excess reserves from the calculation of the supplementary leverage ratio could force large US banks to slash their exposures, industry sources warn. This, in turn, could sap liquidity from repo lending, a cornerstone of money markets.

The Federal Reserve ordered the exemption last April to ease leverage capital charges caused by ballooning excess reserves and increased market-making in US Treasuries at top banks. It is due to expire on March 31, and the Fed has so far given no indication that it will grant an extension.

“I’ve had more calls in the past week on this than I have in the past year. It’s very front of mind from an investor standpoint,” says a rates strategist at one systemically important US bank.

Market participants are concerned that without an extension, big banks may have to scale back their balance sheets, disrupting key markets like Treasury repo.

“It’s reasonable to expect that commercial banks and their broker-dealer affiliates will pull back on providing funding to institutions that hold Treasuries and trade in Treasury markets, as well as making markets in Treasury securities themselves,” says Bill Nelson, chief economist at the Bank Policy Institute, a bank lobby group.

JP Morgan has led calls to prolong relief of the supplementary leverage ratio (SLR). During the bank’s January 15 earnings call, chief financial officer Jennifer Piepszak said the exemption “should either be made permanent or, [at a] minimum, be extended”.

With the relief, the bank’s SLR at the holding company level stood at 6.9% at end-2020 – the lowest among the eight US global systemically important banks (G-Sibs). Without the relief, it would have been 5.8%.

Under US regulation, G-Sibs have to hold a 3% minimum SLR plus a 2% buffer at the holding company level. The rules are stricter at insured depository institution (IDI) level, where G-Sibs conduct the bulk of their deposit and lending activities. Here, banks must meet a minimum requirement of 6%, based on the activities within the subsidiary. At JP Morgan, for example, the IDI SLR was 6.35% in the fourth quarter of 2020.

Federal banking agencies introduced separate relief for the IDI SLR in May, allowing G-Sibs to carve out reserves and Treasuries at this level, too. There was a proviso, though. Banks had to seek approval from regulators before making capital distributions such as dividend payments. Just two banks – Goldman Sachs and HSBC North America – took advantage of this relief.


The supplementary leverage ratio is the US version of the Basel III leverage ratio, introduced as part of a package of measures in response to the 2008 financial crisis. The leverage ratio is designed to prevent banks from overextending themselves and ensure they have enough of a capital buffer against a market shock.

To increase the ratio, a bank can either increase its Tier 1 capital – which makes up the ratio’s numerator – or cut on- and off-balance-sheet exposures, which make up the denominator. JP Morgan stated in its fourth-quarter presentation that it may have to issue or retain more capital or reduce deposits to stop the ratio from biting.

Francisco Covas, head of research at the Bank Policy Institute, says: “If the relief is not extended, the G-Sibs will start shedding assets, which eventually could go beyond reserves and start affecting other activities they participate in, and to the extreme could even affect lending.”

Headroom required

Excess reserves at the largest US banks swelled last March and April, as the Federal Reserve purchased billions of dollars in Treasuries and other securities to help inject liquidity into the financial system. Meanwhile, companies across the US drew on credit lines to shore up cash reserves in the teeth of the coronavirus crisis, lodging much of the money with their banks.

Banks responded by increasing their cash deposits at the Fed, which count as an on-balance-sheet exposure. This put downward pressure on supplementary leverage ratios.

Now, banks that are close to their SLR limits may decide to restrict the amount of US Treasuries and excess reserves they hold on their balance sheets. As of end-2020, US Treasuries and excess reserves made up roughly 19% of JP Morgan’s total leverage exposure. At Citi and Bank of America, the shares were 18% and 16%, respectively.

Whether the return of the fully loaded SLR forces banks to scale back exposures depends, in part, on their plans for capital distributions to shareholders. The Fed barred buybacks and capped dividends payable by systemic banks last June. In December, it eased these restrictions, allowing buybacks and dividends in the first quarter of this year up to an amount equal to firms’ average quarterly profit for the last four quarters.

JP Morgan announced $30 billion of buybacks following the Fed announcement. This would cut its holding company-level SLR to 5.4% with the relief excluded, using end-December figures.

Some believe banks should look to limit shareholder distributions in order to maintain a healthy leverage ratio. “If banks need more capital to fund their balance sheet growth, then why wouldn’t our first order of business be for them to retain more capital?” asks Gregg Gelzinis, a policy analyst at left-leaning think-tank Center for American Progress.

Executives at the systemic banks argue, though, that leverage capital charges have been pushed excessively high as the Fed has grown its balance sheet – meaning a recalibration of the measure is warranted.

“The system has expanded. When the original calibrations for G-Sib [surcharges] or leverage were calculated, did the regulators contemplate the scale of the system being as big as it currently is? If not, we’re getting to a point – and it’s not that far away – in which this [SLR] becomes the more binding measure,” says the head of capital and liquidity management at one US G-Sib.

“We want these rules to behave appropriately over time, so that as the system flexes and moves, we don’t find ourselves with greater and greater requirements,” the head adds.

One compromise may be to exempt reserves from the SLR while keeping Treasuries in scope. “Extending the SLR exemption for reserves has clear net positive benefits. The cost-benefit for SLR exemption of Treasuries is less clear,” says Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business.

Duffie adds that an exemption of Treasuries from the SLR should be dependent on a compensating increase in risk-based capital requirements, possibly with a floor for government securities.

But treating Treasuries differently from cash could distort repo markets even further, by incentivising banks to hoard cash and shirk government bonds. “Everything that we experienced in September 2019 will happen again, meaning Treasury repo stops and rates totally go off the charts,” says the head of capital and liquidity management at the US G-Sib.

To extend the relief or otherwise alter the SLR, the Fed can opt to introduce an interim final rule, which would apply immediately following a vote by the Federal Reserve Board. This was the route taken when the relief was first introduced. Alternatively, the agency may issue a proposal, which would be bound by the Administrative Procedures Act – necessitating a public comment period and public notices of proposed and final rulemaking. Time is tight for a full proposal process.

“It would be nice to give the market some lead time, if they were going to do something about this one way or another,” says the rates strategist. “The worst thing they can do is not say anything, and then do [an announcement] Thursday night before it expires, because by that point the banks have already made decisions.”

Correction, February 9: This article has been amended to correct Bill Nelson's title. He is chief economist at the Bank Policy Institute, not the chief executive officer

Additional reporting by Robert Mackenzie Smith

Editing by Alex Krohn

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