PRIMER: To exempt, or to not exempt; Fed to announce SLR exemption's fate in coming days

Analysis details (15:40)

Fed Chair Powell Wednesday said that there would be an update on whether US regulators would extend Supplementary Leverage Ratio (SLR) relief for US banks in the coming days, with current Treasury and reserve carve-outs scheduled to expire on March 31st. The NY Fed on Wednesday also announced that it was to raise the counterparty cap of the overnight reverse repo facility from USD 30bln to USD 80bln, which some have taken as a signal that the regulators will not be extending the SLR relief.

WHAT IS SLR: Banks' supplementary leverage ratio requirement (SLR) is a capital rule that requires institutions to hold a certain percentage of capital against total assets. In April 2020, regulators exempted Treasuries and deposit reserves from banks' SLR calculations, which allowed these banks to build balance sheets by purchasing Treasuries without hindering their SLRs (some analysis suggests USD 300bln of Treasuries were accumulated over the last year). This arrangement is set to expire at the end of March, and if it were not extended, banks could have to hold more capital against their holdings of Treasuries if SLRs suddenly become the binding capital constraint on banks, which some warn may result in reduced demand for government debt, perhaps triggering in a wave of Treasury selling, which could in-turn reduce funding for other Treasury investors, stoke volatility in fixed income markets, and potentially result in significant market disfunction.

POTENTIAL IMPACT: There is much speculation regarding the impact on banks, funding markets, and bond markets if such an extension does not come. Banks would still be compliant with leverage ratios even if the exemption were to expire today, analysts note, and some argue that fears of wholesale Treasury selling by banks to comply with the SLR are unwarranted given the rule would not become a binding constraint, at least immediately. Nonetheless, so long as these fears are present, traders cannot discount the possibility of an episode of pressure in rates if, as several analysts assume – including Credit Suisse’s highly influential funding analyst Zoltan Pozsar – that the Fed does not announce an exemption extension. Indeed, Pozsar thinks the Fed’s move to raise the counterparty cap at the reverse repo facility is “foaming the runway” for the end of the SLR exemption, "the Fed made this adjustment practically preemptively  – the o/n RRP facility is not being used at the moment, so there are no capacity constraints yet, while repo and bill yields aren’t trading negative yet". Meanwhile, the analyst believes the cap rise will ensure that money market rates won’t trade negative and that money funds don’t face a collateral shortage that would force them to gate inflows and deflect institutional flows to the bills market.

RESERVES FLOOD: There are also intertemporal considerations: while the immediate impact on money markets might be limited, the financial system risks being flooded with reserves (via the Fed’s QE) and Treasuries (expanding deficits), which may see bank balance sheets breach regulatory limits as these continued to grow. Essentially, if Treasuries and reserves have non-zero weights in regulatory calculations, they risk becoming constraints on bank balance sheets, threatening the stability of bonds and funding markets as intermediaries pull back. Analysts at UBS think that if the exemption was not extended, it could be a problem for market liquidity, and would bias interest toward products like TBAs, futures, swaps; "That will be offset in shorter durations by banks trying to spend cash, but in longer durations we think the effect will be significant,” UBS writes, noting that adjustments to the reverse repo facility do not fix the SLR problem, it just buys a little time before banks hit the constraint. “Too many reserves are being created by TGA drop/QE to drain them all without raising crowding out issues,” UBS thinks.

THE POLITICS: There are also issues of inter-agency politics to consider. The Fed implemented the rule at the bank holding company level in April, where the exemption is automatically implemented. Note, the Federal Reserve Board has unilateral power to implement changes at the parent holding level but has to coordinate in a troika – composed of the Fed, OCC, and FDIC – to make adjustments at the subsidiary level. Indeed, it wasn’t till June that the troika announced the option for the subsidiary bank operating companies to opt-in for exclusion of Treasuries and reserves from the SLR. However, very few banks opted into the rule at the operating level due to the “strings attached” that would complicate capital distributions. But, if balance sheets continue to growth amid the increasing supply of reserves and Treasuries, banks could soon wish to opt into the SLR exemption, if the option were still available to them. Fedspeak has been sparse on the issue, and recent commentary from the FDIC Chair showed somewhat of an aversion to the extension. Furthermore, the FDIC has said in the past that it believes the SLR rule is the most important post-GFC reform, while the Basel committee has said that it should be a simple ratio and that once you start removing items, it becomes a slippery slope – not to mention fresh comments from progressive lawmakers, such as Senator Elizabeth Warren, who are calling for no further exemption in belief it supports Wall Street. While the Fed may or may not be keen for an extension, it is most likely facing the political difficulty of getting the FDIC and OCC on board, where views aren’t always aligned.

18 Mar 2021 - 15:40- Fixed IncomeResearch Sheet- Source: Newsquawk