BPI: Fix Bank Leverage Requirements Now, in Advance of Upcoming Treasury Market Stress

Recognizing the damage that a binding leverage ratio could do to the liquidity of Treasury markets during periods of stress, the Federal Reserve took action in 2020 to mitigate the effect of its dramatic increase in the level of reserve balances on banks’ balance sheets. When those actions expired earlier this year, the Fed stated that it would revisit the calibration of leverage ratios, and especially the supplementary leverage ratio (SLR). Leverage ratios are currently binding for some of the very largest banks, which are also the most significant providers of intermediation in the Treasury market. Given the agreed-upon need to fix leverage ratio requirements, and two potential stress episodes on the horizon—QE tapering and a debt-ceiling debacle—we demonstrate in this post that the banking agencies should take action to fix the requirements now, rather than looking back with regret in the wake of significant Treasury market volatility because they hadn’t acted earlier.

Here we will explain why the Federal Reserve should modify the SLR before it starts to taper its Treasury purchases, and before a possible debt-ceiling debacle in early December. Tapering will require private-market participants to absorb a larger share of ongoing issuance of debt by the Treasury. Meanwhile, failure (or even the threat of failure) to reach agreement on the debt ceiling in December will put severe strains on the Treasury bill and money markets and will result in high inflows into bank deposits, putting additional downward pressure on banks’ leverage ratios. If tapering or a debt-ceiling crisis happen before changes to leverage ratios are made, there is heightened risk of another episode of Treasury market dysfunction. We discuss specific measures that could be taken to eliminate existing disincentives for bank-affiliated securities dealers to offer liquidity to the Treasury and Treasury repo markets under stress, with no material impact on the overall resiliency of the banking system.

The full article is available at https://bpi.com/fix-bank-leverage-requirements-now-in-advance-of-upcoming-treasury-market-stress/

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