Proposal to move bank regulation goalposts signals underlying problems in financial system

If a formula spits out a number you don't like, just change the formula so you get a better number!

That’s exactly what the Bureau of Labor Statistics did to the Consumer Price Index formula in the 1990s. Because the CPI kept indicating price inflation was too high, the BLS tweaked the formula to spit out a lower inflation number.

Now the International Swaps and Derivatives Association (ISDA) is trying to talk the Federal Reserve into changing the formula for the supplementary leverage ratio (SLR) to make bank balance sheets look better.

This proposal sends some alarming messages about the stability of the banking system and confidence in U.S. government debt.

What is the SLR and why do they want to change it?

The SLR is calculated by dividing the bank’s tier 1 capital (capital held in a bank's reserves and used to fund business activities for the bank's clients) by all assets on the bank’s balance sheet, including U.S. Treasuries and deposits at Federal Reserve Banks.

Banks use the SLR to calculate the amount of equity capital they must hold relative to their total leverage exposure. Regulations imposed after the 2008 financial crisis require category I, II, and III banks to maintain an SLR of 3 percent. “Globally Systemically Important Banks” are required to keep an extra 2 percent SLR buffer.

During the pandemic, the Fed temporarily altered SLR requirements, allowing banks to exclude Treasuries and reserves from the formula’s denominator. This made it easier to maintain the required SLR ratio.

As a Federal Reserve note explained, the banking system “exhibited considerable strains” during the reign of COVID-19. As the pandemic unfolded and governments began shutting down economies, banks quickly liquidated risky assets and increased their cash holdings. This resulted in a “sharp increase in bank deposits.”

According to the Fed note, “The associated rise in the overall balance sheets had the potential of causing their tier 1 capital levels to fall below the amount required by the SLR, which could have resulted in banks limiting their provision of financial services.”

To provide some relief, the central bank made temporary changes to the SLR formula effective April 1, 2020. The emergency rule allowing banks to exclude U.S. Treasuries from the calculation expired a year later.

In a letter addressed to the Federal Reserve, along with the FDIC, and the Office of the Comptroller of Currency, the ISDA urged these government agencies to make that “temporary, emergency” rule change permanent.

“To facilitate participation by banks in U.S. Treasury markets—including clearing U.S. Treasury security transactions for clients—the Agencies should revise the SLR to permanently exclude on-balance sheet U.S. Treasuries from total leverage exposure, consistent with the scope of the temporary exclusion for U.S. Treasuries that the Agencies implemented in 2020.”

The proposed rule change would allow banks to exclude both “on-balance sheet U.S. Treasuries that a bank holds in inventory or as part of its liquidity portfolio, as well as U.S. Treasuries the bank has received in a repo-style transaction to the extent the bank records the U.S. Treasuries on its balance sheet.”

This raises a question: does this indicate that the banking system is under “considerable strain?”

What would a change to the SLR mean in practice?

According to the ISDA, the change would “promote the stability of the U.S. Treasury market.” The organization also said it would more broadly “help support market liquidity in the context of projected increases in the size of the U.S. Treasury market and the importance of bank participation in the market.”

From a practical standpoint, it would incentivize banks to buy and hold more U.S. Treasuries by allowing them to hold them on their balance sheet without impacting their SLR. This would be good news for the U.S. Treasury Department, given that is selling billions of dollars in Treasuries every month to cover the massive government budget deficits.

The impact would be similar to quantitative easing.

In effect, the proposed change in the SLR would boost demand for Treasuries, driving prices higher and interest rates lower than they otherwise would be. Given the impact of Treasury yields on the broader bond market, it would also likely push other borrowing costs lower.

It would also enable banks to lend more money than they otherwise could under the current SLR scheme. This is a form of money creation and would have an inflationary effect.

European Investment Bank senior policy analyst Antonio Carlos Fernandes called this proposal “alarming.”

In an article published by Medium, Fernandes identifies several reasons banks would love to adjust the SLR requirements to exclude U.S. Treasuries.

1. Treasuries are generally considered “risk-free” assets because they are backed by the “full faith and credit” of the U.S. government. The proposal to exclude them from the leverage ratio requirement implies banks perceive them as more risky. This could “potentially undermine confidence in U.S. government debt." 
2. The SLR is intended to backstop risk-based capital requirements and to ensure banks don’t become overleveraged, even with “safe” assets. The carveout for Treasuries would weaken these protections.
3. The formula change would incentivize banks to load up on U.S. Treasuries. Fernandes called this a “concentration of risk” that would “heighten the interconnectedness between the banking system and government debt, posing systemic risks.”
4. The request to exclude Treasuries from the SLR could signal “broader anxiety” about the U.S. fiscal situation and government debt levels. Given the spending problem in Washington D.C., this anxiety is certainly justified.

Fernandes summed up the situation this way:

“Any perception that banks require special exemptions for holding U.S. government debt could shake global confidence in Treasuries as a safe haven asset and could impact the status of the U.S. dollar.”

Trouble in the banking system?

This proposal also casts doubt on the notion that the banking system is “sound and resilient.”

A year ago, rising interest rates precipitated a banking crisis kicked off by the collapse of Silicon Valley Bank. The Fed managed to paper over the problem with a bailout program.  

Through the Bank Term Funding Program (BTFP), banks, savings associations, credit unions, and other eligible depository institutions were able to take out short-term loans (up to one year) using U.S. Treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral.

Instead of valuing these collateral assets at their market value, banks were able to borrow against them “at par” (Face value). It would be like the bank extending you a second mortgage based on the original value of your house after a flood caused significant damage. Normal people would never get this kind of sweetheart deal.

The BTFP was set up to address a specific problem that took down Silicon Valley Bank and two other financial institutions.

SVB went under because it tried to sell its undervalued bonds to raise cash. The plan was to sell the longer-term, lower-interest-rate bonds and reinvest the money into shorter-duration bonds with a higher yield. Instead, the sale dented the bank’s balance sheet with a $1.8 billion loss driving worried depositors to pull funds out of the bank.

The BTFP gave banks facing similar problems an alternative. They could quickly raise capital against their bond portfolios without realizing big losses in an outright sale. It gave banks a way out, or at least the opportunity to kick the can down the road for a year.

The BTFP shut down in March.

Fernandes said the timing of this ISDA proposal should raise some questions about the global banking system.

“With the conclusion of the BTFP, are banks signaling a potential banking crisis on the horizon? Or perhaps, even more significantly, are they indicating concerns about an impending international financial crisis, given the central role that U.S. Treasuries play in the global financial markets?" 

Money Metals President Stefan Gleason said these are just “more games” to try to make banks look safer than they really are, “even though they have a lot of exposure to U.S. bonds." 

“Especially after they've experienced big value declines and an erosion in bank equity, causing their measured leverage to increase.”

Gleason is right. When you dig beneath all of the technical, regulatory mumbo-jumbo, this is just another example of the powers that be moving the goalposts to keep the game tilted in their favor.