The Federal Reserve on 19 March announced (see release here) that the temporary changes to its supplemental leverage ratio, or SLR, will expire as scheduled on 31 March. These changes, which were implemented last year, aimed to ease strains in Treasury markets resulting from the COVID-19 pandemic. Although Treasury market liquidity has improved since the disruptions last March, it’s still reliant on bank intermediaries that must shift their business to comply with these rules. In the near term, we think global systemically important banks (GSIBs) will reduce their Treasury-collateralized short-term lending (i.e., repo) business, require larger bid/ask spreads to intermediate between clients, and encourage institutional depositors to shift into money funds. Although the changes should augment the safety and soundness of the banking system, they likely will come at a cost of reducing Treasury market liquidity and driving down yields on the lowest-risk short-term assets.
SLR changes aimed to ease strains
Last March, in an effort to support banks’ ability to facilitate bond market liquidity during the severe Treasury market disruptions, the Fed announced a temporary exclusion of reserves and Treasuries from the supplemental leverage ratio for the largest U.S. banks. While Dodd-Frank reforms implemented in the wake of the 2008 financial crisis had the benefit of ensuring bank capital was adequate to weather the severe economic shock from COVID-19, the requirements came at a cost of constraining banks’ ability to make markets, even in the lowest-risk short-term assets.
Before the exclusion, GSIBs were required to increase their capital positions or reduce their balance sheets to mitigate the increase in reserves (and deposits) that coincided with the Fed’s crisis-period liquidity programs and large-scale asset purchases. These constraints resulted in a significant reduction in banks’ ability to serve as financial intermediaries and exacerbated the bond market disruptions. At the time, the Fed relaxed this regulation, as well as others, in an effort to ease financial conditions and maintain the overall flow of credit to the real economy. These changes had an immensely positive impact on market functioning, in our view (see our paper “Lessons From the March 2020 Market Turmoil”).
Since then, market liquidity has improved along with the outlook for the economy. As a result, congressional leaders have encouraged the Fed to allow the temporary SLR changes to expire, to augment bank capital buffers and further enhance the safety and soundness of the banking system. However, these calls have come despite the $1.5 trillion growth in Fed deposits, or reserves, and over $4 trillion in additional Treasury issuance. And with reserves and Treasuries expected to grow another $4.4 trillion this year, the expiration of the rule will have implications for bank balance sheets and Treasury markets.
Market liquidity is still fragile
Notwithstanding the improvements in Treasury market functioning since last March, market liquidity is still fragile. Over the past month, as banks prepared for SLR expiration, market liquidity has once again deteriorated, contributing to wider bid/ask spreads, lower order-book depth, and greater concessions needed to take down the larger supply of Treasuries issued to fund government COVID-19 relief spending. At the same time, yields on money fund assets, including the shortest-maturity Treasuries, and short-term collateralized lending have compressed. Looking forward, the expiration of the SLR changes will only exacerbate these trends. Indeed, growing demand for the lowest-risk short-term assets may even contribute to negative yields on Treasury bills – similar to the 2015 experience.
In the short run, in an effort to optimize their business around these rules, we think the largest banks that must comply with the SLR will take several steps to mitigate the earnings impact of the additional capital charges. These steps include encouraging institutional depositors to move their money into money funds or Treasury bills, possibly by charging additional fees; reducing lower-margin activities, including short-term collateralized lending and Treasury trading; and requiring more expected return (term premium) to hold Treasuries outright.
Many of the underlying factors that contributed to Treasury market dysfunction in March 2020 are still weighing on markets today. With the expiration of the SLR changes, this is especially true. And while the Fed has pledged to study possible permanent changes to ensure the rule is effective in an environment of higher reserves, in the interim, Treasury markets likely will shoulder the costs of less market liquidity and more volatility.
Tiffany Wilding is a PIMCO economist focused on North America. Jerome Schneider is a managing director and PIMCO’s head of short-term portfolio management, and Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates. All are contributors to the PIMCO blog.