SLR Reform and “Doom Loop”

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SLR Reform

Last week I wrote about Supplementary Leverage Ratio (SLR), one of the broadest capital ratios used to regulate US banks. We provided conditional support for the idea of ​​adjusting the Department of Treasury’s SLR requirements. This means that banks don’t have to hold that much capital to the Ministry of Finance, so they can buy more of them. We believe this proposal makes sense as long as it helps financial market liquidity. But we are also concerned about the timing of change and the motivations behind it.

As Treasury Secretary Scott Becent points out, allowing banks to purchase more U.S. debt will support the Treasury market. At the same time, the administration lent its support for the Genius Law. This encourages Stablecoin publishers to keep T-builds. Taken together, the two initiatives appear to be an effort to support domestic demand for federal debt at the moment when foreign buyers appear to be stepping on.

There is nothing inherently wrong with an administration seeking to reduce our borrowing costs. But there are costs associated with proceeding with it this way. According to Steven Blitz, chief economist at TS Lombard, initially it relates to the purpose of the bank in the first place.

(If the bank has more Treasury Departments), the banks begin to look like an institution with intermediate funds between the depositors and the federal government, rather than between the depositors and the private sector. . . This means that the growing generation is increasingly in the hands of the government, the private sector, the opposite of what the Republicans have historically hoped for.

It depends heavily on how the SLR is specifically regulated. However, we can imagine a scenario in which banks are ultimately supposed to consider the Treasury as providing the best or best risk-adjusted returns of equity capital. It would certainly lower the Treasury yields, but it could also reduce lending to the actual economy. Also, as Blitz noted that it has not been edited, banks prefer short-term T-builds and prioritize the long-term Treasury ministry. Adjustments to SLR may not be able to benchmark 10-year yields. This appears to be as much the government would later be as low as short-term yields and rushing the yield curve.

However, the biggest risk may be structural. As we learned during the European debt crisis of the 2010s, banks in countries that own many of their sovereign debt could lead to a “loop of destiny.” If you jump on sovereign bond yields, the bank will make sure that the equity cushion will fade as the bond prices drop. This can lead to a vicious cycle when the economy weakens. The weakness of the bank means that it will no longer buy debts from sovereignty that it requires so much to raise new capital, and banks may need assistance at the moment when the government cannot provide it.

The US will not immediately enter this type of debt spiral. According to Blitz, US banks own approximately 6% of US outstanding debt. This is low by historical standards and is below the percentage of Italian sovereign debt owned by Italian banks in the recent crisis. And, as Ignazio Angeloni of the Institute of European University, points out, the structure and conditions of the European and American monetary systems are different, especially in Italy.

In Italy, there was an issue with the risk of defaulting sovereigns. . . Italy’s debt levels are much higher, and Italy is part of the currency union. Italy cannot print money or monetize debt. . . Debt levels are rising (in the US), but we are not there yet. And the Fed is still strong and independent. You can pay at any time.

That being said, we are in a sensitive economic moment. Foreign demand for the US Treasury appears to be waning. Congress passed a massive spending bill, causing uncertainty in the bond market. And the Fed has a tense relationship with the White House. In the long run, adding a thicker Treasury tier to a bank’s balance sheet can lead to a dangerous feedback loop.

In the short term, high exposure to the long-term Ministry of Finance poses real risk to the bank itself. The collapse of Silicon Valley Bank and the First Republic Bank demonstrated that a high period (sensitivity to interest rates) can help banks run. Rates are already higher than in recent history, but long-term yields have risen and stagflation is still possible. It may not be a great moment to drive a bank for ten years of finances.

There is a good reason for the Treasury to adjust the SLR requirements, and there is probably a reserve held by the Fed. However, reforms can be measured and offset by risk-based capital requirements. Regulators should also consider the simultaneous impact of Genius Act.

And we need to keep our expectations down. Supporters of the Fed’s SLR reform are linked to liquidity in the financial market at moments of stress. Treasury supporters are more interested in US debt sustainability and Treasury yields. SLR reforms could help with both issues. However, there is a mix of evidence for the former, but the latter has its own risks and will likely affect T-bill more than T-bill. Nor will make much of a difference in the face of rising deficits, slower growth and attacks on the Fed independence.

(writer)

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