Fed Should Consider Changing SLR. Why Is It So Crucial?

Without a possible change to the supplementary leverage ratio (SLR), US banks' ability to take on more bonds might be hindered. It may place the economy at stake, when a recession hits.

Hi there! In today’s post I will:

• explain what is the SLR and why it’s so important,

• what the high US structural budget deficit has to do with the SLR,

• how the so-called ‘Basel III Endgame’ can look like in the US.

The SLR was a frequently repeated word in 2020, when the Fed decided to modify this measure in order to “ease strains in the Treasury market resulting from the coronavirus and increase banking organizations' ability to provide credit to households and businesses”¹. The modification facilitated US banks to take in an avalanche of freshly created deposits and thereby increase their Treasury holdings thereafter. Four years later, the topic is in the limelight again with Fed’s Bowman explicitly suggesting a possible change to the SLR. The ratio, like any other capital requirement, is designed to ensure that the banking system remains safe and sound during periods of stress. However, if capital requirements are too stringent, then it could come with a cost to the real economy. So what would the revised SLR look like, and how might it affect the ability of monetary and fiscal authorities to support the economy in the event of another recession?

What is the SLR?

Bowman's comments last week prompted me to revisit the subject and write about it in this article. In his speech he said²:

While risk-based and leverage capital requirements are intended to be complementary and promote the safe and sound operation of the banking system, the eSLR can disrupt banks' ability to engage in Treasury market intermediation, which we saw occur in the early days of market stress during the pandemic. I consider reform of the eSLR to fall in the category of "fixing what is broken." This is an issue that would be prudent to address before future stresses emerge that could disrupt market functioning.

Before we move further, it’s important to explain what the SLR is. Namely, it’s one of the capital requirements which US banks need to comply with.

The table below presents a set of these requirements which are divided into the three major groups³. The SLR is a leverage ratio calculated by dividing Tier 1 Capital by Total Leverage Exposure. Tier 1 Capital is composed of Common Equity Tier 1 Capital (ordinary shares) and Additional Tier 1 Capital (AT1 bonds which are converted into equity if a specific event occurs). Total leverage exposure is composed of both on- and off-balance sheet assets.

Source: SIFMA

It’s good to know that, unlike other leverage ratios like Tier 1 Capital ratio, the SLR is a non-risk weighted capital requirement. It means that both risk-free reserves and corporate bonds are treated in the same way. Why? It’s simply a safeguard that those risk weights might not appropriately capture the risks of the assets banks hold.

In general, US banks are obligated to hold 3% of Tier 1 Capital in relation to total leverage exposure. This threshold applies to all banks being classified between I and III category. Global systematically important banks (GSIBs) are in the category I, banks with total assets exceeding $700 billion are in the category II, while those with total assets in excess of $250 billion are in the category III. On top of that, GSIBs are subject to a 2% surcharge - the enhanced supplementary leverage ratio (eSLR). It’s basically what Bowman referred to in his speech I mentioned at the beginning of this post.

Source: SIFMA

How does the SLR work in practice?

Take a bank with $5 billion of capital. If it wants to comply with the SLR requirement, its balance sheet shouldn’t exceed $100 billion for GSIBs or around $166 billion for banks falling in the category II or III (in practice, other capital requirements also prevent the bank’s balance sheet from growing). As a result, the bank needs to optimize its balance sheet in a way to maximize a return on assets it holds. Therefore, it may choose to reduce its low-yielding assets like reserves.

Where do these reserves come from? Well, when someone wants to park $100 at the bank, it pushes up the bank’s liabilities by this amount and its assets also rise by $100 (reserves). Thus, there was an outflow of deposits from one bank to another one. The former lost some reserves (its balance sheet lowered), while the latter gained some reserves (its balance sheet increased). The system-wide amount of reserves remains unchanged though.

When the COVID-driven crisis hit in March 2020, the Fed chose to exclude reserves and on-balance sheet Treasuries from calculating the SLR ratio. Why it did it? In response to the pandemic, the Treasury decided to issue a lot of bonds, notes and bills to finance a fiscal impulse to the economy. However, market sentiment was very poor then, that’s why the Fed needed to step in to facilitate the process. As a consequence, the Treasury General Account (TGA) swelled by $1.4 trillion in less then 4 months. When the Treasury started spending its money, then banks were literally flooded with cash.

Various balance sheet constraints, including the SLR, would have prevented some banks from taking in such a gargantuan amount of deposits if no action had been taken. Ultimately, the banks would have charged additional fees or even offered negative rates. Thus, the SLR discourages the banks from holding low-yielding assets. This impact can be particularly visible if a wall of deposits suddenly removes the TGA and goes to the private sector.

Why is a possible change to the SLR so important these days?

The simplest answer to this question is the chart below. Namely, the US structural budget deficit is quite high at this stage of the business cycle (and the outlook doesn’t bode well either⁴). Looking at the prior decades it turns out that the deficit tended to be well below 5% of GDP once each recession hit. The COVID crisis was an exception, but it offers an important lesson for us.

Source: FRED, CBO, own elaboration

First of all, if a recession began now, the starting point for fiscal largesse would be quite demanding. Nonetheless, I doubt that the Treasury wouldn’t offer a sizeable fiscal impulse anyway. If so, it means that the banks would have to embrace a lot of bonds again to finance fiscal packages. If their capacity isn’t enough, then the cost of such aid would be high (unless the Fed steps in again).

What’s also important, the ongoing QT process hasn’t dented the amount of reserves yet because of the constant drainage of the Fed’s Reverse Repo facility (RRP), albeit it’ll change before long once RRP is finally emptied (it should happen in the next several weeks). When it happens, the banks’ ability to purchase more bonds will start decreasing.

As such, the Fed should consider changing the SLR. What could the SLR change concern? In my view, the Fed ought to consider excluding reserves from calculating the ratio. Taking into account that we are in the ample reserves regime, counting in reserves is no longer practical. For instance, the BoE decided many years ago that reserves would be exempted from the SLR. Should Treasuries also be exempted? I have some doubts here. Why? Reserves are truly risk-free even during times of stress. Treasuries seemingly are also risk-free, albeit it changes all of a sudden once market sentiment deteriorates. It was well seen in the spring 2020 during the so-called ‘dash for cash’ episode. Finally, don’t forget that the Treasury is also likely to launch its buyback programs this year to improve liquidity and cash management⁵.

More stringent regulations on the horizon

In the light of the above considerations, it’s also worth mentioning an incoming significant change for the US banking sector. I mean the final Basel III reform (aka ‘Basel III Endgame’) which in the US is expected to come into force from July 2025 (the same in the UK, while in the EU the reform should be applicable as of January 2025)⁶. US banks are now pushing the Fed to exempt specific deposits and Treasury securities from leverage computations⁷. The Fed hasn’t offered its final say yet.

Even as the proposal regarding US banks is likely to be more stringent compared to the EU or the UK, the Basel Committee on Banking Supervision (BCBS) seems to back such a solution if this one is needed to provide the sufficient soundness of the US banking sector. BCBS’s chair Pablo Hernandez stressed that Basel agreements only set minimum regulatory standards⁸. According to the FT article, the new rules would drive a 16% increase in banks’ capital requirements in the US, compared to 9% in the EU and just 3% in the UK.

Where does this difference come from? The US proposal prevents banks from using their own internal models to work out how much capital they need to hold against their loan books (the Standardized Approach). In the two other jurisdictions regulators are expected to permit to use internal models (the Advanced Approach). Using internal models allows for more accurate capture of risks (tailored to each bank). However, it also means greater volatility in capital requirements among various banks. It remains to be seen what the final solution will be in the US.

---

Did you enjoy the piece? Please share this post and help me reach out to an ever-growing audience.

1. https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm

2. https://www.federalreserve.gov/newsevents/speech/bowman20240117a.htm

3. I plan to write a separate post regarding US banking regulations, hence I won’t describe each ratio this time.

4. https://www.cbo.gov/publication/58946

5. https://twitter.com/Insider_FX/status/1687174708993630209?s=20 (the tweet in Polish)

6. https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/focus/2023/html/ecb.mpbu202312_focus01.en.html

7. https://bnnbreaking.com/world/us/us-banks-to-urge-federal-reserve-to-amend-supplementary-leverage-ratio-regulation/

8. https://www.ft.com/content/dafc7d80-b052-40f2-b1a5-54f103608a48