A shift in bank leverage calculations adds risk

| March 19, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Fed has decided to let temporary rules lapse on March 31 that have helped banks since last April hold record amounts of Treasury debt and excess reserves. The Fed in the same announcement has also promised to get comments on new rules in short order, making the practical impact of its decision hard to gauge. But a lapse in the temporary rules without substantial replacement would likely force important shifts in bank assets and liabilities, put pressure on money markets and add volatility to MBS and other spreads. The Fed decision at least for now has added risk to the market.

The Fed last April decided to temporarily exclude Treasury debt and excess reserves from calculations of banks’ supplemental leverage ratio, a key measure of capital adequacy. Regulators require banks and other depositories with more than $250 billion in assets or more than $10 billion in foreign exposures to hold a minimum ratio of capital to risk. The capital is Tier 1 capital, including common equity, retained earnings, reserves and certain preferred debt. The risk is total assets and certain other exposures. The eight US G-SIBs have to hold a minimum 5% SLR. Other depositories have to hold a minimum 3%. Most banks and their regulators prefer the SLR to be well above the minimums.

The Fed last April reasoned its newly launched program of QE would flood the system with reserves, putting pressure on SLR. Excluding reserves and Treasury debt would let banks absorb and safely reinvest system liquidity. And banks have done exactly that. From last March through January, banks added $1.44 trillion in excess reserves and $316 billion in Treasury debt, investing as well in other securities and loans. With another $1.44 trillion in QE expected this year, another $1.1 trillion flowing out of Treasury cash balances and $2.8 trillion in fiscal stimulus passed since December, many in the market expected the Fed to extend the exclusions.

Political controversy may have weighed in the Fed’s decision to let the exclusions lapse. Sen. Sherrod Brown (D-OH), chair of the Senate Banking Committee, and Sen. Elizabeth Warren (D-MA), a senior member, sent a February 26 letter to the Fed, the OCC and the FDIC asking for the exclusions to end. The letter cited regulators’ own calculations that the exclusions relieved banks from having to raise $55 billion in capital to satisfy SLR. It urged regulators to let the exemptions lapse and encourage banks to raise capital by ending dividends, share buybacks and other capital distributions.

The Fed’s hint of new adjustments to SLR could signal a compromise where some or all excess reserves get excluded from the calculation, but Treasury debt comes back in. This would hinge on the argument that reserves pose no interest rate, credit, counterparty or operating risk to banks and should not require capital. It would allow banks to absorb most of the tsunami of cash set to hit balance sheets in 2021

If the Fed excluded excess reserves from a revised SLR, banks would face heavy pressure on a few fronts:

  • Raise equity,
  • Sell assets, or
  • Discourage new deposits

Banks might choose to raise equity to support their current heavy positions in reserves and Treasury debt. But raising equity seems unlikely given low loan demand and tight spreads in securities markets. Alternatively, banks could sell Treasury debt to reduce their asset base and relieve pressure on SLR. And on the liability side, banks would face pressure to discourage non-core deposits, likely diverting them to smaller banks not subject to SLR or into the money market mutual fund market.

JPMorgan reported an SLR of 6.9% at the end of 2020 and said without the temporary relief it would have dropped to 5.8%, uncomfortably close to the minimum for a G-SIB. JPMorgan called for extension and said otherwise it would have either raise equity, start turning away large deposits or do both. Citigroup has also called for extending the rules.

The Fed decision is likely to send banks scrambling to think through the implications of the Fed’s next steps. In a recent letter to bank regulators, SIFMA noted that while none of its members would breach SLR if the Fed let the Treasury and reserve exemptions lapse on March 31, the expected flow of deposits through 2021 would eventually bind banks’ activities. It seems highly likely a modified version of the SLR exemptions will resurface shortly with new impact on bank assets and liabilities and the markets where banks transact. Since banks hold more than $21 trillion in assets, more than US GDP for 2020, small changes in banks’ incentives will likely be felt across fixed income.

* * *

The view in rates

The rates markets will likely be a little nervous until the Fed tips its hand on SLR. The weighted average maturity of bank Treasury holdings through September stood at 3.6 years, so the belly of the curve has the most exposure.

The 10-year note has finished the most recent session at 1.72%, solidly in the middle of the expected range of 1.50% to 1.95% for the balance of the year. That is exactly the range in the six months before pandemic. My colleague, Stephen Stanley, is expecting extraordinary growth and inflation pressure this year, a start to tapering in October and Fed liftoff by the spring of 2022. If that unfolds, the 10-year note could jump above 2.00%. Equilibrium is probably at 2.50%, but that should take much more evidence of sustainable growth and inflation beyond the surge anticipated as pandemic ends and monetary and fiscal policy kick in.

The Treasury yield curve has finished its most recent session with 2s10s at 155 bp, off a bit from the recent 5-year high. The 5s30s curve has bounced sideways since mid-February. As 30-year rates approach 2.50%, they should have less room to move up, and the 5s30 curve should start to flatten. Inflation expectations measured by the spread between 10-year notes and TIPS have moved up a bit over the last week to 231 bp, the highest level in five years. Real rates continue to move up, too. Volatility has jumped back above levels last seen around the elections in November and back to levels of last April.

A heavy supply of cash continues to reduce repo rates, Treasury bill yields and LIBOR. SOFR recently printed at 1 bp.

The view in spreads

The changes on bank balance sheets since the start of February have added spread volatility to markets that should last between one and three months. Extension of MBS duration by nearly 1.75 years has left many banks more exposed to interest rate risk than preferred and inclined to rebalance by reinvesting in cash assets. That takes a strong bid out of the MBS market, and spread volatility in MBS is leaking into other markets. Spreads in credit should eventually tighten back towards pre-February levels as a heavy flow of cash forces banks back into their usual habitat. The new $1.9 trillion round of fiscal stimulus, easy monetary policy and a narrowing pandemic should start showing up in growth and earnings over the next few quarters. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. Consumer credit should outperform corporate credit.

The view in credit

Consumers in aggregate are coming out of 2020 with a $12 trillion surge in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Credit should improve as warmer weather and better vaccine distribution allows more opening of economic activity. Distribution and vaccine uptake through the end of 2021 should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.

This version of the article, posted on March 22, 2021, at 10a, corrects earlier errors in the analysis of impact from excluding excess reserves from SLR.

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