Reuters reported yesterday that US regulators are discussing if the 6% Supplementary Leverage Ratio has gone too far to stifle financial market activity. Whether 3% or 6%, it seems clear that the Leverage Ratio has become the biggest gating factor in securities finance transactions. If US regulators backtrack, that is going to release a huge amount of financial market activity.
According to the Reuters article, “Regulators taking another look at costs of Wall Street safety rule“:
“[The Supplementary Leverage Ratio] has turned out to be quantitatively more of a problem than some people had anticipated,” said Jeremy Stein, who was a Fed governor when the supplementary leverage ratio was adopted.”
Right, and on the other hand, it has been exactly the huge problem and anti-financial business measure that some other people expected. We appreciate that the Leverage Ratio has reduced fire-sale risk, which has been a huge issue for US regulators for years. On the other hand, we and many others make the connection between the Leverage Ratio, widening spreads in financial market products and sharp moments of illiquidity. The best example of this is the flash crash in US Treasuries on Oct 15, 2014; the US regulatory community’s final report on the matter is illustrative. But other regulatory releases continue to argue that liquidity is fine and good.
“Privately, some regulators are now asking themselves whether the cost of complying with the rule may diminish its benefits, according to people familiar with internal discussions. The Federal Reserve and other central banks are analyzing the rule and its impacts.”
Repo is the poster child for the negative impacts of the SLR, especially as some banks have pulled back their repo activity very substantially. Our analysis shows repeatedly that while the LCR puts some breaks on business, and the NSFR will apply hard breaks unevenly, the Leverage Ratio is the biggest impediment of all. It would be hard to understate how much more financing business banks would be doing if there were no Leverage Ratio today. This is not an argument for eliminating the Leverage Ratio, but rather an observation of how severe the limits have been following its implementation.
Reducing the SLR might be in the interest of regulators themselves in protection of other priorities, for example in debt financing.
“In nearly two years big banks have had to set aside more capital for holding government debt, Treasury yields have inched up. JPMorgan estimates that higher interest payments will add up to $260 billion over the next decade.”
This is the same example of the impact that a Financial Transactions Tax would have on US Treasuries. Looked at another way, the SLR is a tax that leads to less trading activity in the markets. Less liquidity means more risk, which means that investors want a higher return for their investment. And who pays interest to investors on US government bonds? Its the same regulators that are setting the SLR rules. More details on this well-known problem can be learned from Sweden’s financial history in the late 1980s and early 1990s.
So what’s more important, a riskless banking system or banks that take on some risk in exchange for vibrant and low cost financial markets? This is an old question and one that regulators are again struggling with. The implication from the Reuters article is that the pendulum may be swinging back towards some degree of flexibility on the risk that banks take on. This is no done deal, but the alternative is a riskless, high cost and inflexible financial market system, and that has never been a regulatory priority.
Keep a close eye on what happens next in this conversation. A reduction in the US SLR would add some risk into the system, and would add some needed vibrancy and liquidity back to US financial markets.