In 2016, FedFin issued a paper urging a radical rethink of leverage capital standards. Good things come to those who wait. Still, why we had to wait so long is hard to fathom given the predicted, manifest systemic problems due to the leverage standards evident as early as 2019 and in the two systemic crises that followed in short order.
What to do? Revisiting rules he once refused to touch, former Fed supervisory-head Dan Tarullo last week argued for an end to the enhanced supplementary leverage ratio (eSLR), with this add-on charge for the largest U.S. banks replaced by higher risk-based standards And tougher treatment of Treasury holdings. Indeed, Mr. Tarullo opposes taking Treasuries, even just short-term ones, out of the leverage denominator, pressing also for continued inclusion of central-bank deposits. A lower SLR, he suggests, captures the risks of these obligations in concert with his proposed capital add-ons.But what risk to central-bank deposits really pose? If they are at the Fed, which holds the vast majority of U.S. central-bank deposits, then these funds are as liquid and robust as the Federal Reserve itself. If the Fed’s no good, then neither is the dollar and much, much else is wrong that even the toughest eSLR cannot fix.
Further, imposing a capital requirement on reserves held at the Fed makes it less likely that banks will be liquid in any form of run or market crisis. The banking agencies could of course again exempt reserves in a crisis just as they did in 2021, but that could also again be too late and, next time, not enough.
Treasury securities do pose risks, but these are not the risk of nonpayment for which credit-risk standards are designed. This is, though, captured by the market-risk rules and interest-rate risk is supposed to be addressed by add-on capital charges a buttressed by effective supervision (so-called Pillar 2 rules) Thus, Treasuries aren’t capital free, or at least they shouldn’t be.
Advocates of a high eSLR cite the 2023 crisis precipitated by unrealized losses largely in USG and agency holdings. However, it isn’t credit risk that cratered these positions; this was a failure by both high-flying banks and bottom-dwelling supervisor to capture the interest-rate and potential liquidity risk associated with large holdings of long-term Treasury obligations aby banks dependent on uninsured deposits.
The leverage ratio is not a proxy for effective supervision, well-designed liquidity rules, risk-based standards capturing germane Treasury-related risks, or the absence of a functioning discount window. Imposing it instead of targeted, effective, and proven buffers to Treasury-market risk only ensures that the incentives behind the 2023 crisis still go unaddressed and that the largest U.S. banks will stand aside the next time – and there will be a next time – panicky investors dash for cash.
If the next round of risk-based capital standards really brings order from the current chaos, then we can simply scrap the leverage ratio. For now, the agencies should reduce the leverage ratio to a level – three percent or so – that ensure it remains a backstop instead of a proxy charge on sovereign obligations and assets with little to no credit risk. Basel has from time-to-time proposed ways to do this, but chickened out from a final approach because the global body’s high-risk members took offense. U.S. agencies must also stop hiding in corners and make Pillar 2 a meaningful adjunct to the capital charges in concert with effective supervision.
A sensible, holistic U.S. capital regime must assign risk-based capital charges where risk occurs, using specialized tools such as the market or operational backstops were appropriate and employing liquidity-risk rules to address liquidity risk for which leverage standards are now a totally counter-productive substitute. Just fiddling with the eSLR number will do little to reform the current regulatory mishmash protecting banks at grave cost to financial-market integrity, the long-term preservation of critical regulatory perimeters, robust growth, and financial stability.