We recently mentioned that the US regulators have asked the large banks to comment on a proposal to recalibrate—and most likely lower—what is called the supplementary leverage ratio. The supplementary leverage ratio determines the extra capital buffer large banks have to hold because they are large and therefore more systemically risky.
Well, that process is a little more convoluted than the banks just writing YES to the proposal in the comment section.
The regulators wear multiple hats. When they are not stress testing the largest banks, they ensure financial markets are running as stable and smoothly as possible. And they need the banks’ help with that.
The banks help by investing in treasury notes and bonds and by putting some of their savings into the treasury. Some even go for extra credit by acting as prime brokers. That keeps the money market liquid and interest rates as low as possible, and that is important in credit-driven economies.
Alas, some hats are hard to wear together.
A large bank might find itself in the disincentivizing situation that holding or facilitating treasuries isn’t worth the while because it adds too much to the capital ratio. Remember that the capital ratio is determined by risk-weighted assets over capital, and the fastest way to make it smaller is by shedding risk-carrying assets, like treasuries.
That is not a great situation, and the regulators try to prevent it, especially in times of stress. During the pandemic, treasuries and federal deposits were temporarily exempt from the supplementary leverage ratio, and those happy days are what the regulators are hoping to bring back with their proposal.
However, the former chair for the FDIC, Sheila Bair, argued in FT that lowering the buffer for the largest banks would not necessarily make the banks participate more in the treasury market, and it might even make matters worse when in the throes of a systemic crisis.
Think of it this way. Large banks often consist of two banks in one: an FDIC-insured bank, and an investment bank. The FDIC-insured bank, in broad terms, takes deposits to make loans. The investment bank maximizes return on risky assets backed by their own capital or borrowed funds.
Freeing up capital on the FDIC-insured side does not guarantee the investment side will see treasuries as the asset with the highest return for the risk.
And with good reason, the two bank sides are kept fairly separate. If the FDIC-insured side is exposed to the risk of the investment side, it can go really bad, like Silicon Valley Bank bad.
Community and regional banks mostly just have the FDIC-insured side. So should a large bank go down because of excessive risk on the investment side, smaller banks bear some of the systemic cost because everybody’s insurance premium to the FDIC goes up. That is one argument for large banks having a supplementary leverage ratio in the first place.
Meanwhile in Canada, the bank regulator, OSFI, announced that they are keeping the Domestic Stability Buffer—the equivalent of the supplementary leverage ratio—at 3.5% for the six largest banks.
Even if the Canadian banks are doing well on the capital side, financial system vulnerabilities are high, though stable.
Household indebtedness has come down but is still above historic levels, and many Canadian mortgages will renew at a higher rate level than when they originated over the next 18 months. On the commercial real estate side valuations are still under pressure.
Also, while the trade tantrums do not show in economic indicators yet, the uncertainty of it all puts the wait-and-see hat on OSFI and the banks.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.