Fed faces tough choice as big banks' capital relief deadline looms

The Federal Reserve is on the verge of making a tricky decision: Extend regulatory flexibility for big banks and anger some key progressive Democrats, or let that relief expire and risk volatility in Treasury markets and on bank balance sheets.

Analysts are split on whether returning to the pre-pandemic supplementary leverage ratio could have unintended consequences. The current flexibility for big banks' SLR ratios is set to expire March 31, at which point banks' holdings of U.S. Treasurys and deposits at the Fed would once again factor into the calculation and force banks to hold more loss-absorbing capital against those assets.

Investors have become "increasingly nervous about the potential market impact" if the Fed does not extend its SLR flexibility, according to Priya Misra, head of global rates strategy at TD Securities. Removing the carve-outs could prompt banks to take a step back from the U.S. Treasury market, weakening demand just as an increase in U.S. government spending raises the supply of the debt needed to pay for it, she wrote in a note to clients.

But the SLR relief's impacts have been somewhat overhyped, with the tweaks being "only marginally beneficial" to markets, according to Mark Cabana, a rates strategist at Bank of America.

Fed officials have refused to tip their hand on whether they think an extension of the SLR relief is necessary, though they have said their change to an internationally agreed upon capital rule was intended to be temporary. Analysts expect an update on the issue this week as the Federal Open Market Committee gathers to discuss its interest rate policies and economic conditions.

Big banks have argued that letting the capital relief expire could have negative consequences, such as giving banks less capacity to add Treasurys to their balance sheets at a time when investors are selling off bonds and a larger presence from banks could serve as a cushion.

But the two Democrats who chair the committees overseeing the Fed — Sen. Sherrod Brown, D-Ohio, and Rep. Maxine Waters, D-Calif. — have pressed the central bank to let the SLR relief expire. Doing so would help ensure banks have enough capital available to absorb COVID-19-related loan losses, as would prohibiting banks from distributing capital to shareholders, they say.

"I urge your agencies to stop weakening bank requirements, including by allowing the temporary SLR relief to expire, to help ensure the resilience of our financial system through the remainder of this pandemic and economic recovery," Waters wrote to the Fed and other bank regulators.

As the Fed's decision nears, analysts are weighing whether the central bank may opt for some sort of compromise, such as extending the SLR relief for banks' reserves but letting it expire for their Treasury holdings.

The SLR relief has helped banks deal with the mass of deposits that flooded into accounts as the U.S. government approved trillions of dollars in fiscal relief. The Fed's ongoing monthly bond purchases of $120 billion have also pumped reserves into the banking system.

The Fed's flexibility has particularly helped money center banks like JPMorgan Chase & Co. and Citigroup Inc. Without the SLR relief, JPMorgan's ratio would be 5.8%, above the 5% minimum for global banks but significantly closer to it than before the pandemic. Citigroup's SLR would be 5.9% without the relief, compared to 7% when Treasurys and reserves are excluded.

JPMorgan CFO Jennifer Piepszak said recently that without an extension of the SLR relief, the bank may be forced to "shy away from taking new business" and redirect larger customers elsewhere. The bank could also issue preferred shares or retain more capital to ensure its leverage ratios stay comfortably above any minimums and extra buffers, she said.

Wall Street's critics say that is just fine. Community banks "would be happy to accept deposits that large banks may reject," Sen. Elizabeth Warren, D-Mass., and Brown wrote in a letter to Fed Chairman Jerome Powell. The Fed could also ease some of the burdens by prohibiting big banks from distributing capital to shareholders, they added, saying allowing capital to flow out of banks is "inexcusable" when the economy remains at risk.

Big banks have already started taking steps to shift large commercial customers' excess deposits elsewhere, including lowering the rates they pay on deposits and setting balance limits for some clients. Those actions could pick up if the SLR relief goes away, analysts say.

Another option would be for big banks to buy fewer Treasury securities going forward. Banks have amassed larger portfolios of Treasurys over the last year, partly because the SLR relief gave U.S. government debt preferential treatment.

Banks could very well decide to live with lower SLR figures than they had before the COVID-19 pandemic, given that they would still be comfortably above their minimum requirements, BMO Capital Markets analyst Dan Krieter said. That would mean the SLR relief would have little to no market impact. But if banks chose to return to their 2019 SLR figures, that could prompt them to reduce their Treasury holdings by some $200 billion or more, Krieter said.

That could put some pressure on the Treasury market, where interest rates on bonds help determine mortgage rates and other consumer borrowing costs. A large enough increase in bond yields — if that were to happen — could go against the Fed's goal of keeping interest rates low to spur economic growth.

"The SLR is going to go away eventually, but with all this uncertainty now, it would just seem to make the most sense to keep the SLR in place for three to six more months," Krieter said.

Padhraic Garvey, ING's global head of debt and rates strategy, said he doubted that an expiration of the SLR would have a big effect on the Treasury market, partly because banks would remain comfortably above their minimum SLR ratios.

But the possibility of bond market stress could weigh on Fed officials' minds, he said, as would the potential for investors to interpret the expiration of relief as "early evidence that the Fed views this crisis to be over."

If that happens, some investors could push up their expected timeline for the Fed to begin pulling back its support for the U.S. economy. And that would go against the message from the Fed: that it will be patient in raising short-term interest rates and reducing its $120-billion-per-month in bond purchases.

"[That] would create problems that they don't really need to be dealing with right now," Garvey said.