Earlier this week, Bloomberg made public Treasury’s inquiry into how new rules adversely affect market liquidity.  We understand that the leverage ratio (LR) is top of the study’s hit list – and a good thing too as demonstrated in a FedFin study last year.  Although some think it’s hard to get LR relief along with the reform agenda sketched out most recently in the Statement of Administration Policy (SAP) on financial reform, the Administration can get its Glass-Steagall 2.0 cake and allow big banks to eat a whole lot of LR relief too.  The big question isn’t if the Administration wants this – it does.  What I don’t know is if political reality will trump market reality and force the Administration to accept continuation of a leverage ratio despite all its adverse impact on systemic risk. 

First, though, it’s important to explain how reducing the U.S. version of the LR either through the numerator or – more likely – the denominator makes a big difference in market liquidity.  Without going into the daunting technical details of how the repo market works, the heart of the problem lies in the current application of the high LR to the assets on a big bank’s balance sheet that land there in the course of an array of market making, clearing, and settlement activities. 

Chastened by the 2014 flash crash, The Obama Administration looked at the LR and concluded that it probably didn’t threaten liquidity because the liquidity indicators it selected – largely those in benign market conditions – showed nothing to worry about.  The Fed generally put a similarly happy face on market liquidity, but it is also so worried about repo-market liquidity that it has considered an array of structural changes that might restore liquidity without any reduction in the LR, especially the supplementary one applicable to U.S. GSIBs.  These have included trying to come up with a new market utility the Fed might run – a Congressional no-go zone – lots more issuance of short-term Treasury bills – a taxpayer cost Treasury won’t much like – or Fed acceptance of the growing role of non-banks in this systemic-critical arena – a solution that spooks the Fed, not to mention almost everyone else.  In short, policy to date has simultaneously said market liquidity is fine so the LR can stay as is even though policy-makers are looking anxiously for new ways to ensure ample liquidity in a flash-crash repeat.

The Trump Administration review is under FSOC’s aegis and is clearly weighing the Fed’s LR wants with the market’s liquidity need.  Unlike the Obama Administration Department, we think the Trump-led Treasury will propose significant changes to the LR.  Ducking the top-line number and all the love now being lavished on a ten percent LR, Treasury will try to adjust the denominator to exclude from the ratio key assets – cash, variation margin, and even liquid assets considered high-quality ones in the U.S. liquidity standards.  This Fed won’t like changing the denominator much and this FDIC will still more strongly oppose changes to the LR denominator, but it’s for Treasury to propose and then Trump appointees to decide when and if the President gets his nominations confirmed.  All FSOC can do is recommend policy and we very much expect it to target the LR when it does.

How can the Trump team get more market liquidity with a liberalized LR and at the same time meet the SAP’s goals of “well-capitalized” banks?  Simple – shove repos, securities, financing, and other non-traditional, albeit critical, activities into a non-traditional subsidiary of an insured depository.  Then, confine the high LR to the traditional bank, give the non-traditional one a far more liberal LR, and give the parent holding company little, if any, consolidated capital requirement.  This formula is a slam-dunk win for big banks and thus not likely, but variations on it could still provide both considerable LR relief and a far more liquid market.

How to adhere to the SAP’s commitment to “well-capitalized” banks and cut the mustard with fans of a ten percent LR?  These formidably include FinServ Chairman Hensarling and FDIC Vice Chair Hoenig, not to mention a lot of powerful trade associations, commentators, and editorial boards. 

Back to the denominator we go.  It takes some technical expertise even to find the LR denominator, let alone know what happens when assets come out of it.  Over time and with changes to key regulatory personnel, look for significant changes to the LR that ease a lot of the pain not only of a ten percent ratio, but also of ring-fencing traditional and non-traditional activities in the Glass-Steagall 2.0 configuration.