Fed Lets Break for Banks Expire but Opens Door to Future Changes

on Mar19
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The Federal Reserve said on Friday that it would not extend a temporary exemption of a rule that dictates the amount of capital banks must keep in reserve, a loss for big banks and their lobbyists, who had been pushing to extend the relief beyond its March 31 expiration.

At the same time, the Fed opened the door to future tweaks to the regulation if changes are deemed necessary to keeping essential markets functioning smoothly. Banks are required to keep easy-to-access money on hand based on the size of their assets, a requirement known as the supplementary leverage ratio, the design of which they have long opposed.

The Fed introduced the regulatory change last year. It has allowed banks to exclude both their holdings of Treasury securities and their reserves — which are deposits at the Fed — when calculating the leverage ratio.

The goal of the change was to make it easier for the financial institutions to absorb government bonds and reserves and still continue lending. Otherwise, banks might have stopped such activities to avoid increasing their assets and hitting the leverage cap, which would mean having to raise capital — a move that would be costly for them. But it also lowered bank capital requirements, which drew criticism.

As a result, the debate over whether to extend the exemptions was a heated one.

Bank lobbyists and some market analysts argued that the Fed needed to keep the exemption in place to prevent banks from pulling back from lending and their critical role as both buyers and sellers of government bonds. But lawmakers and researchers who favor stricter bank oversight argued that the exemption would chip away at the protective cash buffer that banks had built up in the wake of the financial crisis, leaving them less prepared to handle shocks.

The Fed took a middle road: It ended the exemption but opened the door to future changes to how the leverage ratio is calibrated. The goal is to keep capital levels stable, but also to make sure that growth in government securities and reserves on bank balance sheets — a natural side effect of government spending and the Fed’s own policies — does not prod banks to pull back.

“Because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the Board may need to address the current design and calibration of the S.L.R. over time,” the Fed said in its release. It added that the goal would be “to prevent strains from developing that could both constrain economic growth and undermine financial stability.”

The Fed said it would “shortly seek comment” on measures to adjust the leverage ratio and would make sure that any changes “do not erode” bank capital requirements.

“The devil’s going to be in the details,” said Jeremy Kress, a former Fed regulator who teaches at the University of Michigan. “I want to make sure any changes the Fed makes to the supplementary leverage ratio doesn’t undermine the overall strength of bank capital requirements.”

The temporary exemption had cut banks’ required capital by an estimated $76 billion at the holding company level, although in practice other regulatory requirements lessened that impact. Critics had warned that lowering bank capital requirements could leave the financial system more vulnerable.

That is why the Fed was adamant in April, when it introduced the exemption, that the change would not be permanent.

“We gave some leverage ratio relief earlier by temporarily — it’s temporary relief — by eliminating, temporarily, Treasuries from the calculation of the leverage ratio,” Jerome H. Powell, the Fed chair, said during a July 2020 news conference. He noted that “many bank regulators around the world have given leverage ratio relief.”

Other banking regulators, like the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, took longer to sign on to the Fed’s exemption, but eventually did.

Even though the exemption had been a tough sell in the first place, persistent worries over Treasury market functioning had raised the possibility that the Fed might keep it in place.

The government has been issuing huge amounts of debt to fund pandemic relief packages, pumping Treasury bonds into the market. At the same time, reserves are exploding as the Fed buys bonds and the Treasury Department spends down a cash pile it amassed last year. The combination risks filling up bank balance sheets. The fear is that banks will pull back as a result.

That’s because the supplementary leverage ratio measures a bank’s capital — the money it can most easily tap to make through times of trouble — against what regulators call its “leverage exposure.” That measure counts both its on-balance sheet assets, like Treasurys, and exposures that do not appear on a bank’s balance sheet but may generate income.

If banks fail to keep capital on hand that matches with their assets, they are restricted from making payouts to shareholders and handing executives optional bonuses.

Banks desperately want to avoid crossing that line. So if there is any danger that they might breach it, they stop taking on assets to make sure that they stay within their boundaries — which can mean that they stop making loans or taking deposits, which count on their balance sheets as “assets.”

Alternatively, banks can pay out less capital to make sure their ratio stays in line. That means smaller dividends or fewer share buybacks, both of which bolster bank stock prices and, in the process, pay for their executives.

The Financial Services Forum, which represents the chief executives of the largest banks, has argued that the temporary exemption should be rolled off more slowly and not end abruptly on March 31. Representatives from the group have been lobbying lawmakers on the issue over the past year, based on federal disclosures. And the trade group — along with the American Bankers Association and the Securities Industry and Financial Markets Association — sent a letter to Fed officials asking for the exemptions to be extended.

“Allowing the temporary modification to leverage requirements to expire all at once is problematic and risks undermining the goals that the temporary modification are intended to achieve,” Sean Campbell, head of policy research at the forum, wrote in a post this year.

Some banks have themselves pushed for officials to extend the exemption.

“This adjustment for cash and Treasury should either be made permanent or, at a minimum, be extended,” Jennifer A. Piepszak, JPMorgan Chase’s chief financial officer, said on the bank’s fourth-quarter earnings call.

Ms. Piepszak added that if the exemption for reserves was not extended, the supplementary leverage ratio would become binding and “impact the pace of capital return.” She has separately warned that the bank might have to turn away deposits.

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