- Key insight: Bank holding companies of primary dealers have as much as $5 trillion of capital headroom as a result of changes to the enhanced supplementary leverage ratio implemented by regulators earlier this year, according to Federal Reserve Vice Chair for Supervision Michelle Bowman.
- Expert quote: "So far this year, evidence shows that leverage ratio reforms have improved Treasury market functioning and strengthened its resilience to stress by relaxing regulatory balance sheet constraints." —Federal Reserve Vice Chair for Supervision Michelle Bowman
- Forward Look: While early signs are encouraging, Bowman said the true benefits of the reforms will become evident during a period of market stress, when dealer balance sheets are most likely to be overwhelmed.
The Federal Reserve's top regulator said
In a Thursday afternoon speech at an event hosted by the Atlantic Council in Washington, D.C., Fed Vice Chair for Supervision Michelle Bowman said the large banks that are subject to the eSLR are no longer bound by the capital requirement thanks to changes that make its calculation dynamic and bank specific.
As a result of this shift, Bowman said, banks and their primary dealer operations are able to intermediate Treasuries more effectively, thus reducing volatility and minimizing fragilities that have threatened to disrupt the government funding market.
"The impact of this recalibration has been encouraging," she said. "So far this year, evidence shows that leverage ratio reforms have improved Treasury market functioning and strengthened its resilience to stress by relaxing regulatory balance sheet constraints."
Bowman said the reforms to the leverage ratio, also known as the eSLR, have created an additional $5 trillion of additional headroom for primary dealer banks.
While only a fraction of this capacity has been put to use — with dealer Treasury positions increasing from $600 billion to $700 billion during the first months of implementation — the biggest jumps came from the banks that were most constrained by the old regime.
"This pattern suggests that the sharp increase in positions was driven by dealers taking advantage of additional headroom created by the eSLR modification," Bowman said.
Elsewhere in the banking system, the shift in behavior has been more pronounced, she said, noting that leveraged exposure across the largest, global systemically important banks has increased by roughly $900 billion since the rule went into effect — equal to roughly 50% of the leveraged capacity at the GSIBs prior to the change.
Citing findings from the Fed's Senior Financial Officer Survey in March, Bowman said much of this leveraged exposure came from increased Treasury holdings and involvement in repurchase agreement, or repo, markets.
Bowman said this increased activity by banks has helped absorb large debt issuances by the government this year. She also noted that banks are now holding more Treasury securities and hedging those exposures by shorting Treasury futures. In doing this, banks are reducing the market's
"This increase in dealer holdings has likely absorbed some positions previously held predominantly by hedge funds as part of the cash-futures basis trade," Bowman said. "These conditions are likely to lessen the influence in Treasury markets of investors holding highly leveraged trading positions that are particularly vulnerable to adverse shocks in funding, cash, or derivatives markets."
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Overall, Bowman said the change has improved market liquidity and functioning, narrowed the bid-ask spreads between buyers and sellers, reduced intraday volatility during auction cycles, calmed funding conditions and stabilized bond prices despite a surge in new debt issuance.
"This initial view is very heartening for us, that [the eSLR] is functioning as intended and will help to ease any market conditions that could become stressful before they occur," Bowman said during a question-and-answer session that followed her prepared remarks.
The eSLR was implemented in the U.S. in 2014, stemming from the international accord known from the Basel Committee on Banking Supervision known as Basel III. In her speech, Bowman noted that the requirement was designed to be a risk-insensitive "backstop," meaning it was meant to take a back seat to risk-based capital standards for banks.
Yet, as the overall supply of risk-free government debt has
Last year, the Fed, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency addressed this concern by replacing the flat approach to eSLR calculation to one based on each individual bank's systemic risk score.
"This new approach tailors the eSLR to each GSIB's systemic footprint and produces a calibration that is consistent with the objective for supplementary leverage ratio requirements to act as a backstop to risk-based capital requirements," Bowman said.
Basel III endgame
During the question-and-answer session, Bowman said she expects to finalize another key part of the capital framework for large banks — the so-called Basel III endgame — before the end of the year.
Bowman acknowledged that there was a fair amount of "skepticism" in and around the banking system about whether the Fed would move forward with implementing the revised risk-weighted capital framework with her at the helm of regulation. Yet, the Fed, FDIC and OCC
"I think everyone was surprised that we were able to introduce it within less than a year of my becoming vice chair for supervision," she said, crediting the Fed's staffers with working closely with their counterparts at the other agencies for the speedy rollout. "The Fed staff has done incredible work in a very rapid way to learn the lessons of the last proposal, to ensure that we're approaching things from a real risk-based approach and taking a fresh approach to how we should be thinking about capital requirements in the aggregate."
Bowman's predecessor as vice chair for supervision, Michael Barr, spearheaded a Basel III endgame proposal that drew
Before that, then-Vice Chair for Supervision Randal Quarles was also
Monetary policy
Bowman also weighed in on the course of monetary policy during the event, saying she is not convinced that further interest rate hikes will be necessary.
Bowman said she agreed with the Federal Open Market Committee's decision to increase the federal funds rate by a quarter percentage point last month, but said she would like to see how that change ripples through the economy before endorsing an additional hike.
"Inflation remains above our target but after the committee's action in September, what we need to have is a better understanding of how the underlying trends in the economy and how financial conditions are evolving going forward," she said. "So, I don't currently see an urgent need for further action. And I think we need to better understand the totality of the data, but remain attentive to the risks."
In the FOMC's
In a speech of his own on Thursday afternoon, Fed Vice Chair Philip Jefferson called last month's rate increase "an important step" to keep expectations in check and "validate the public's confidence" that the Fed will bring inflation back down to 2%. But he said it is too soon to say whether additional tightening is needed.
"Since our September meeting, yields across the term structure have increased further, a sign that investors are reassessing the evolving macroeconomic landscape. My colleagues and I will need to come to our own judgment, which may take more time," Jefferson said. "I will continue to assess whether underlying trends suggest that inflation will return to target with sufficient speed. With more data in hand, such trends may lend themselves to better discernment, as may the appropriate stance of monetary policy."
