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Supplementary leverage ratio exemptions still only temporary, Fed's Quarles says


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Supplementary leverage ratio exemptions still only temporary, Fed's Quarles says

The Federal Reserve has no plans to make permanent the supplementary leverage ratio exemptions it instituted in the wake of the COVID-19 pandemic, Vice Chair for Supervision Randal Quarles said Oct. 14.

In response to deteriorating liquidity conditions in the Treasury market in the early days of the coronavirus pandemic, the Fed announced in early April that it was temporarily excluding U.S. Treasurys and bank deposits held at the central bank from its SLR calculations.

"Our change to the supplemental leverage ratio is temporary," Quarles said during a systemic risk council webinar hosted by the CFA Institute. "It is not currently in discussion for making it other than temporary."

The SLR standard generally applies to banks with more than $250 billion in assets and dictates, in part, how much capital they must hold relative to their total leverage exposure. In addition to enhancing Treasury market liquidity, the Fed said on the day of the announcement that the move would ensure that banks could continue to lend through the economic downturn as their balance sheets ballooned in response to a spike in consumer deposits.

Quarles said that the changes the Fed made to the SLR have had their intended effect.

"It is clear ... that [the SLR] was a significant disincentive for banks to respond to the pressures on the Treasury market, and when we made that exemption they were able to respond much more fully," he said.

The Fed official was quick to point out some of the potential negative ramifications of making the exemptions permanent.

"If you're going to have a leverage ratio, once you start excepting out of the denominator everything that you think is safe ... then you've just got another risk-based ratio [instead of a leverage ratio]," Quarles said.

Conversely, the vice chair said that implementing a standing facility for repurchase agreements, or repos, that attempts to bolster Treasury market liquidity may be worthy of exploration.

The standing repo facility originally discussed by Fed officials in October 2019 was seen as a way to better control short-term interest rates, including ensuring that its federal funds rate stays within the bounds of its target range. A repo facility that aims to improve the supply of liquidity in the Treasury market would require a significant re-think, he said.

"Our counterparties are the primary dealers, and there would have to be a much broader range of counterparties," Quarles said. "It is conceptually a much more difficult thing for us to think about a standing repo facility to address this issue."

In a separate event Oct. 14 hosted by the Hoover Institute, the vice chair spoke on a number of additional financial market issues as well as topics pertaining to monetary policy.

Despite the fact that financial markets, including the one for Treasury securities, have largely stabilized since the spring, Quarles said Fed officials are still attempting to fully comprehend whether certain aspects of the Treasury market's structure may have contributed to the illiquidity episode.

"It may be that there is a simple macro fact that the Treasury market being so much larger than it was even a few years ago ... may have outpaced the ability of the private market infrastructure to support stress of any sort there," he said. "If that is a major driver of what we saw, can the private market infrastructure grow in a reasonable period of time in order to support this much, much larger market, or will there be some indefinite need for the Fed to ... participate as a purchaser for some period of time?"

Dallas Fed President Robert Kaplan joined Quarles on the panel and clarified why he voted in favor of the Fed's new monetary policy framework, which will allow for inflation to run moderately above its 2% target to compensate for periods in which it undershot its goal.

"The key element of the new framework is in providing greater clarity that the Fed will be less preemptive than in the past in anticipating inflation when the unemployment rate begins to approach our estimate of full employment," Kaplan said.

The Dallas Fed president said he perceives inflation running moderately above 2% to mean 2.25% and that in assessing what level of inflation he can tolerate, he will carefully monitor the rate of change of inflation as well as inflation expectations.

"If inflation expectations are rising rapidly, or spiraling, versus gradually firming, that's going to influence what I would do," Kaplan said. "My tolerance for an inflation overshoot is going to be influenced by the rate of change — the one we're observing and [the one] we're anticipating."