The Federal Reserve’s Supplemental Leverage Ratio (SLR) waiver expired on March 31. Although many banks and lobbyists have lobbied the Fed to permanently retain the waiver or at least extend it, the Fed has decided to terminate the SLR waiver as originally scheduled. However, the Fed plans to re-evaluate the “Supplemental Leverage Ratio” and the possibility of future policy adjustments remains.
The SLR waiver policy expired with the gradual fermentation of the news, the U.S. 10-year Treasury yields rose significantly, and commercial banks may be an important driver of the rise in Treasury yields. March commercial bank reserve levels also fell significantly compared to the previous two months, it can be seen that the expiration of the SLR waiver policy on the total assets and structure of financial institutions and the liquidity of the Treasury market have had a certain impact.
Although the Federal Reserve has repeatedly made it clear that there will be no tightening monetary policies such as interest rate hikes in the short term, changes in regulatory measures such as the withdrawal of the SLR exemption policy that need to be implemented to control systemic risk may also lead to a short-term liquidity tightening in the financial market, which is worthy of attention.
I. SLR is a more stringent capital requirement
The Supplemental Leverage Ratio (SLR) is an important risk indicator for commercial banks, and the formula for calculating SLR is Tier 1 capital/commercial bank exposures, where Tier 1 capital mainly includes common stock and retained earnings, and exposures are the sum of exposures to all assets and non-balance sheet items of the bank, including loans, bonds, reserves and other assets.
The SLR requirement was originally derived from Basel III (hereinafter referred to as “Basel III”), which imposes new and higher requirements on commercial banks for systemic risk prevention. By introducing the leverage ratio and including it in Pillar 1, it closes the gap caused by the difficulty of effectively reflecting the expansion of total assets both on- and off-balance sheet under the capital adequacy requirement, and fills the loophole caused by calculating the capital requirement after converting assets through weighting factors; by expanding the coverage of risky assets, it increases the risk exposure of trading business, “re-securitization “, and counterparty credit risk (CCR) capital requirements for over-the-counter derivatives transactions (OTC derivatives) and securities financing businesses (SFTs), increasing the value-at-risk under stress conditions.
According to Ba III, commercial banks are required to maintain SLR above 3%. after the financial crisis in 2008, in order to prevent risks more effectively, the Federal Reserve further strengthened the SLR requirement by requiring holding companies of commercial banks with the nature of global systemically important banks (G-SIBs) to guarantee a SLR ratio of 5% or more. on April 1, 2020, in the context of the outbreak of the new crown epidemic in the United States context, and in order to enable depository financial institutions to better play their role in stimulating the economy, the Federal Reserve announced the exclusion of U.S. Treasuries and reserves from the calculation of commercial banks’ exposures, the SLR exemption policy mentioned earlier. This move is equivalent to lowering the denominator of the SLR calculation, allowing systemically important commercial banks to respond more comfortably to the 5% SLR ratio requirement.
The main consideration for the withdrawal of the SLR exemption policy is to prevent and control systemic risk
The SLR exemption policy is a product of the Federal Reserve’s response to epidemic risk and balanced quantitative easing (QE), and its policy itself has a certain short-term and phased nature.
The important background for the introduction of the SLR waiver policy was the rapid increase in the scale of commercial banks’ savings during the epidemic and the significant growth of risk-free category balances such as treasury bonds and reserves in the asset structure of commercial banks. During the epidemic, enterprises and individuals sold a large amount of financial assets such as marketable securities to enhance liquidity in response to the recession, and the cash generated from the liquidation of financial assets flowed into banks to become deposits. The cash generated from the liquidation of financial assets flowed to banks and became deposits. Companies, considering the deterioration of the financing environment during the epidemic, might raise funds in advance by issuing bonds and other means, and the funds raised would also be turned into deposits. To meet the challenges of the crisis, the Fed stabilized the market by purchasing a large amount of financial assets and releasing liquidity, which also became deposits after being transferred to various institutions. Data show that during the period from March to June in the run-up to the 2020 outbreak, the size of deposits in U.S. financial institutions grew rapidly, by 16.05% over the three-month period.
Under the dual pressure of a surge in the size of the liability side and limited allocable assets due to market risk, U.S. commercial banks have seen a sharp rise in the size of their allocations to risk-free assets such as Treasuries and reserves (as shown in Figure 2). The data show that the size of Treasury and agency securities holdings on the asset side of all U.S. commercial banks grew rapidly from $3.1 trillion at the beginning of March 2020 to $3.95 trillion at the end of March 2021, an increase of 27.4% in one year. And commercial banks’ reserves deposited with the Fed have also jumped since March 2020, growing from $1.7 trillion in March 2020 to a level of $3.8 trillion in March 2021, a 123% increase.
The rapid growth of the risk-free asset class of financial institutions is bound to form a squeeze on risky assets such as credit under the regulatory framework of SLR 5%. The Federal Reserve as a regulator does not want to see commercial banks fall into recession due to the SLR restriction to reduce the allocation of risky assets such as credit, which is an important reason for the SLR exemption policy.
Maintaining the stability of the Treasury market is another important reason for the withdrawal of the SLR exemption policy. overseas investors’ confidence in U.S. Treasuries was also shaken by the outbreak of the new U.S. crown epidemic in March 2020, and foreign investors’ holdings of U.S. Treasuries declined rapidly by 4% in March 2020, reducing their holdings by about $280 billion. the 10-year Treasury yield then took a short-term jump, rising to a short-term stage of 1.18%. The 10-year Treasury yield then took a short-term jump, rising to a short-term stage high of 1.18%. In order to stabilize the Treasury market and to complement the smooth implementation of quantitative easing, the Fed needed to encourage commercial banks to buy and hold large amounts of Treasuries at that time.
As expectations for the recovery of the U.S. economy gradually heat up, the need to withdraw from phased policies like the SLR waiver, which was introduced in response to the epidemic, has generated heated discussions at the policy-making level. The pro-deferral side believes that withdrawal would lead to reduced credit allocation by banks, while the positive role the policy played in stabilizing the Treasury market would be lost. The opposing party believes that such a policy will damage the risk control mechanism established by U.S. financial institutions after the subprime mortgage crisis and increase the systemic risk of the entire financial market. Some members of the Democratic Party strongly oppose the extension of the SLR exemption policy, arguing that the extension would be a reversal of the trend of financial institutions gradually strengthening their assets and liabilities since the international financial crisis. With the Democratic Party winning control of the presidency and the House and Senate at the end of 2020, the Federal Reserve’s policies on deregulation of financial institutions will face stricter scrutiny from the Democratic Party in the future. The SLR exemption policy withdrawal may be a concession of sorts in the face of political pressure from the Federal Reserve.
SLR exemption policy exit caused by the rise in Treasury yields on the dollar and dollar assets to produce a relatively positive impact, may also be an important influence on the exit policy into action. The rise in Treasury yields facilitates the return of capital from the rest of the world to the U.S. market, pushing up the price of the U.S. dollar index and U.S. dollar assets (e.g., equities). The Federal Reserve “reluctantly” implemented this exit policy only when the positive impact was obvious and the negative impact was manageable.
Although the impact of the SLR exemption policy is limited and the possibility of its return cannot be completely ruled out in the future, at least to a certain extent, it shows that the balance between risk prevention and credit easing of the Fed has begun to tilt towards the former. The future regulation of risk control of financial institutions may, to a certain extent, change the market’s monetary expectations of “easy credit” in a phased manner, inevitably bringing expectations and the possibility of localized and phased contraction of liquidity to the market.
Third, regulatory changes may cause short-term and localized contraction of market liquidity
Although the Federal Reserve interest rate resolution and Chairman Powell repeatedly said that interest rates will not be raised before 2023, monetary policy will continue to maintain loose. But from the impact of this SLR exemption policy withdrawal event, the combination of other factors such as regulatory policy may bring about a “butterfly effect” of liquidity tightening, with far-reaching effects on the U.S. and global financial markets.
1. SLR exemption policy withdrawal will make banks control the scale of U.S. debt holdings, increasing upward pressure on bond yields
According to statistics, the average SLR of major U.S. commercial banks was 7.25% at the end of 2020, up from 6.43% a year earlier, and also significantly higher than the regulatory requirement of 5%. However, temporary compliance is not a reason for commercial banks to take it easy in the face of SLR exemption policy withdrawal. JPMorgan Chase’s Q4 2020 earnings report showed its SLR ratio at 6.9%, but excluding the impact of the waiver policy, it fell to 5.8%, just “one step away” from the 5% regulatory requirement. As the U.S. macroeconomic stimulus continues to expand, the balance sheets of major commercial banks will also expand, and the pressure to maintain a reasonable leverage ratio will continue to rise.
After the SLR exemption is withdrawn, the SLR of major U.S. systemically important banks is expected to fall back to around 6% in 2019 before the policy is introduced. And the trend reflected in the JPMorgan data suggests that SLR for U.S. systemically important banks could fall below 2019 levels into the 5% to 6% range as assets and liabilities increasingly expand. Under compliance pressure, large U.S. banks no longer have much of a way back.
The 5% SLR requirement by itself does not change the current preference of commercial banks for lower risk assets. After the withdrawal of the exemption policy, large banks are bound to tend to scale down their assets and liabilities under the premise that it is difficult to raise huge amounts of capital in the short term. Through simple calculations, it is found that since 2021, the size of money released by the Fed through asset purchases is $120 billion/month, and the incremental amount of money deposited with corporate and personal deposits after the flow of this money into the real economy is about $218 billion/month. And the incremental reserves of the U.S. banking industry deposited with the Fed with cash assets was $243 billion/month, which is basically the same size as the incremental deposit liabilities. This suggests that a large portion of the liquidity released by the Fed flowed back to the Fed in the form of bank cash assets.
Once reserves are included back in the SLR calculation, some commercial banks may reduce their exposure by both lowering cash holdings (i.e., reserves) and reducing their holdings of Treasuries. Lowering cash holdings can be achieved by reducing the overall asset and liability size, such as controlling deposit growth, with a relatively long lead time. Reducing Treasury holdings, on the other hand, can be an “immediate” means of easing compliance pressures.
Federal Reserve data show that in the week ended March 3, primary dealers’ holdings of U.S. Treasuries plunged $64.7 billion to $185.8 billion, a record decline. Usually when investors reduce their holdings of U.S. Treasuries, primary dealers’ inventories of Treasuries increase sharply. This anomaly suggests that commercial banks are taking action to reduce their holdings of U.S. Treasuries before the regulatory exemption expires on March 31.
The 10-year yield has now surged to a narrow range around 1.7%, up 110 basis points from the 0.6% level at the time of the SLR waiver in April 2020, with a continued upward trend. Whether commercial banks continue to reduce their holdings of Treasuries or the U.S. government continues to issue stimulus policies to accelerate Treasury issuance, it will exacerbate the current imbalance between supply and demand in the U.S. Treasury market and keep upward pressure on Treasury yields.
It is worth noting that, due to the continued implementation of low interest rates and quantitative easing, and the sharp rise in Treasury yields, the gap between the Federal Funds Rate, which is the benchmark for the Federal Reserve’s monetary policy, and the 10-year Treasury yield, which is the benchmark for long-term lending, is widening, which will prompt banking institutions to have the incentive to “borrow short and lend long”, thus This will lead to a systemic financial risk of maturity mismatch. In the future, the U.S. monetary authorities may push for the gradual withdrawal of regulatory measures similar to SLR for the sake of controlling systemic risks.
- The withdrawal of SLR exemption policy may weaken the effect of easing policy The withdrawal of the SLR exemption policy will affect the enthusiasm and purchasing power of commercial banks in acquiring Treasuries, which will bring obstacles to the implementation of the new round of fiscal stimulus. Commercial banks, as primary dealers of U.S. Treasuries, assume the important function of market makers in the process of underwriting U.S. Treasuries. After the withdrawal of the SLR exemption, banks are bound to prudently manage the scale of Treasury underwriting to meet the SLR regulatory requirements. After the Biden administration came to power, fiscal stimulus policies came one after another. The first was the $1.9 trillion economic bailout plan passed in early March, followed shortly after by the announcement of a major infrastructure program with a total budget of $2.3 trillion. A significant portion of this series of stimulus policies will need to be financed through the issuance of new bonds. The U.S. Treasury is expected to need to issue $2.8 trillion in bonds in 2021, of which about $1 trillion can be absorbed by the Federal Reserve through asset purchases and other means, while the remaining $1.8 trillion will need to be issued in the financial markets with the help of commercial banks. From the current situation, taking into account the increasing and total size of Treasury holdings in the banking system, new U.S. Treasury issues in 2020 are not fully absorbed by the market. Another data shows that in 2020, commercial banks in the U.S. hold only 4.3% of Treasuries, while funds, insurance and individuals account for a rapid increase to 31% from 17.1% in 2009. After the withdrawal of the SLR exemption policy, the ability of commercial banks to purchase and hold Treasuries will be limited, and higher Treasury yields will increase the future debt burden of the U.S. government, which will have a negative impact on the subsequent issuance of Treasuries. This seems to be evident from the latest issue of the 7-year U.S. Treasury auction. The auction was considered to be the weakest one in recent times due to the high winning rate and lower than expected oversubscription rate, which also created a large impact in the market. This may imply that commercial banks as primary dealers are already ensuring supplemental leverage compliance by controlling Treasury transactions. IV. Risks that China should pay attention to under the SLR exemption policy withdrawal The accelerated recovery of the U.S. economy may trigger the risk of capital backflow. in the fourth quarter of 2020, China had a surplus of US$56.5 billion in direct investment and a surplus of US$54.2 billion in portfolio investment. In the coming period, external capital will also continue to flow into China from direct investment and portfolio investment and other items. In particular, capital inflows under portfolio investment are characterized by short-term, high frequency and large shocks, which may lead to increased exchange rate volatility. The continued capital inflows are likely to increase the vulnerability of financial markets; at some point in the future if certain factors trigger a reversal of capital flows, it could trigger financial risks. With the recovery of the U.S. economy and the implementation of Biden’s 1.9 trillion stimulus plan and the subsequent possible launch of a 2 trillion infrastructure stimulus package on the ground, coupled with the continued fermentation of the SLR exemption policy exit effect, there is a possibility of further upward movement of U.S. bond yields and a consequent narrowing of the Sino-U.S. spread, thus not ruling out the possibility of triggering a rapid return of capital under portfolio investment at a certain point, which in turn will bring greater volatility to the RMB exchange rate This could lead to greater volatility in the RMB exchange rate. Such risk potential needs attention. High U.S. bond yields depress financial asset valuations, driving expectations of financial risk transmission to the domestic market. With the financial markets generally expecting a rapid recovery of the U.S. economy, there will be pressure for U.S. Treasury rates to continue to rise. In order to control the risk of financial institutions, the Federal Reserve withdrew from the SLR exemption policy, resulting in commercial banks selling U.S. bonds in stages and sustained upward pressure on U.S. bond yields. U.S. bond yields are the pricing basis for global financial assets, and the upside will depress global asset valuations and create expectations of falling valuations. Especially when the U.S. bond yields are high, the rapid spread of inflation led to the expected tightening of monetary policy, the implementation of new infrastructure plans when corporate tax increases are put into effect and other factors, it is possible to trigger the United States and even the global financial market turmoil. Under the condition that China’s financial market openness is expanding, such panic expectation and market turmoil may be transmitted to the domestic financial market to a certain extent, bringing market instability. As China’s economic fundamentals are good, the negative impact of SLR exemption policy withdrawal on China’s macro economy and policy is basically controllable. Currently, the US-China bond spread remains at a high level of about 1.5% after the sharp rise in US bond yields, and the endogenous growth momentum of China’s economy is strong, so there is no fundamental environment for significant capital outflows. In the short term, some capital will flow back to the U.S. market due to the rise in U.S. bond yields, but it will be absorbed to some extent by short-term fluctuations in the exchange rate. After rising to a stage high in February 2021 to gradually weaken along with the rebound in the US dollar index, the RMB has depreciated by about 2% cumulatively since early February. The short-term depreciation of the RMB increases the flexibility of the RMB exchange rate and helps hedge against possible capital outflow expectations.
Although higher U.S. Treasury yields have had a significant impact on international capital flows and asset prices, the degree of autonomy of China’s monetary policy should not be weakened. Even during the epidemic-ridden phase, the degree of monetary policy easing in China is very limited, and thus there is no need for significant adjustment. 2021 onwards, monetary policy, that is, has gradually returned to normality, with the growth rates of social financing, credit and M2 gradually slowing down and returning to or close to the levels under normality; interest rate levels are relatively stable, with money market rates and credit market rates basically fluctuating slightly in the horizontal direction; exchange rates The exchange rate fluctuates in a certain range with good flexibility, and the short-term international capital flows are relatively stable in general. The withdrawal of the Fed’s special policies in response to the crisis, especially those related to increasing financial risks, should not trigger the Chinese monetary authorities to take relevant measures in response. However, it may enlighten the Chinese monetary authorities to consider a gradual and reasonable exit from the relevant stimulus policies implemented after the outbreak, with the possibility that the relevant temporary policies involving and increasing systemic financial risks will be withdrawn first, albeit in a very limited way. It is still necessary for macroeconomic policies to pay attention to possible future financial risks and prevent them before they occur.