In its semiannual report to Congress earlier this month, the Federal Reserve said that, “No notable effect on Treasury market functioning followed the expiration in March 2021 of temporary changes to the supplementary leverage ratio, which were implemented to ease strains in Treasury market intermediation in the initial weeks of the pandemic.”  This is technically correct, but substantively misleading.  While it’s certainly true that nothing untoward has since befallen the Treasury market, it’s also noteworthy that securing this happy outcome necessitated expansion of the Fed’s overnight reverse repo program (ONRRP) to almost a trillion dollars.  A trillion dollars – and the ONRRP could still get bigger – is no technicality nor is the ONRRP just some new curtain for a Fed window – it’s an unprecedented market backstop that increases moral hazard to levels yet unknown.

It’s tempting to suggest that the Fed pulled this sleight of hand about Treasury-market stability to duck the thorny question of exemptions to the supplementary leverage ratio (SLR).  As the sentence above notes, the Board did not renew these exemptions in March, thus bringing central-bank deposits into the SLR denominator at all but the custody big banks and altogether ending the leverage exemption for Treasury obligations.  When it pulled this plug, the Fed said it would review the SLR this summer, but summer’s waning and signals from the central bank increasingly suggest so too is any SLR rewrite.

The politics of such a change is fraught, at the least complicating President Biden’s decision to nominate Mr. Powell for a second term.  Chairman Brown has already castigated Mr. Powell for regulatory relaxations past and rumored.  He, Sen. Warren, and all the progressives already campaigning against Mr. Powell would mount the barricades were SLR exemptions to return.

But the question of Treasury-market stability and the SLR is far more consequential than even this important political decision.  As far back as 2015, we issued a paper showing that a binding leverage ratio leads large banks to reduce their deposit taking, sending funds to MMFs and foreign banks (which often then just recycle them into prime MMFs).  This prediction proved right over the next few years, leading the Fed belatedly with the 2020 stress capital buffer (SCB) to declare that one of its goals is to ensure that risk-based – not leverage – capital sets the binding capital constraint.

But, just as the SCB was set to take hold, the pandemic hit. In part because of the SLR’s long-binding impact, MMFs were flush with funds but light on liquidity, creating the systemic catastrophe in March of 2020 that led to huge Fed backstops for this sector as well as many other asset-management products full of the cash banks didn’t want as deposits due to the SLR’s prolonged, adverse impact.  Thus came the SLR exemptions to give banks deposit-taking capacity and, when the exemptions went away, so went the deposit-taking capacity.

As JPMorgan said in its second quarter earnings call, the leverage ratio is now its binding constraint.   Other banks are also refusing deposits and requiring institutional customers instead to hold funds in their MMF products – i.e., outside deposits that would then need to go into assets that, even if only a small-yielding reserve account at the Fed, now trigger the SLR.

This is a dangerous dance between regulatory expedience and financial stability.  Saving Peter – i.e., the MMFs with greater ONRRP access – is an effort to pay Paul i.e., keep short-term rates above nominal zero even though they are already more than modestly negative when adjusted for inflation.  The more money in MMFs thanks in part to the SLR, the more funds there are at risk if rates go below the inflation-adjusted zero lower bound.  MMFs would then have to figure out a way to adjust their asset values in this new, very abnormal.  Many MMFs will go to negative distributions – i.e., taking a bit out of each investor’s pockets each day to make the numbers add up.  Even the sophisticated investors who know to expect this won’t sit still for it, creating another dash for cash in what could prove a still more crushing stampede.

The Fed decided to abjure the COVID exemptions to the SLR on grounds that the leverage ratio should be asset neutral even if some assets – i.e., central-bank deposits and Treasuries – carry no credit risk.  This purity comes at great cost via ONRRP’s new, huge subsidies for MMFs – entities of course outside the costly reach of the capital rules.  And, like many forms of purity, it’s likely to be painful.

The Fed is dedicated to some form of new standards for MMFs, but when these come and what they do remain very much to be seen.  As long as MMFs have large inflows, banks are under a binding leverage ratio, Treasury-bill supply is short, inflation is on the rise, and the delta variant preys upon the vulnerable, downward rate pressure will grow, the ONRRP will have to be opened still wider, and moral hazard will know no bounds.  Chairman Powell earnestly told MMFs this time to expect no mercy, but the ONRRP is still a no-cost safety net and the industry knows to rely upon it.