Fed restoring pre-virus banking rule

WASHINGTON — The Federal Reserve will let a significant capital break for big banks expire at month’s end, denying frenzied requests from Wall Street that it extend the relief to mitigate any impacts to the financial system and the $21 trillion Treasury market.

The reprieve that was granted last April — a response to coronavirus that allowed lenders to load up on Treasurys and deposits without setting aside capital to protect against losses — will expire March 31 as planned, the Fed said in a Friday statement.

Though the regulator has concluded the threat that covid-19 poses to the economy isn’t nearly as severe as it was a year ago, the agency also said that it’s going to soon propose new changes to the so-called supplementary leverage ratio — a measure of their capital against all their assets. The goal is to address the recent spike in bank reserves that has been triggered by the government’s economic interventions during the pandemic.

The expiration of the temporary capital break may disappoint banks and bond traders, as many industry analysts had wanted the Fed to push the deadline out at least another few months, especially since the Treasury market has seen recent volatility. But Fed officials think the market is sufficiently stable and banks’ capital is high enough to return to the pre-pandemic requirement while the agency considers long-term changes.

“Because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the board may need to address the current design and calibration

of the [leverage ratio] over time to prevent strains from developing that could both constrain economic growth and undermine financial stability,” the Fed said.

Central bank officials provided no details on possible modifications, but did say they don’t want the industry’s overall capital levels to change. The Fed added that it will work with the other banking agencies: the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. Those regulators also announced Friday that they will let the temporary relief end March 31.

The agencies’ decision means big banks such as JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. must soon return to their customary leverage ratio.

“It’s a mistake,” Priya Misra, global head of rates strategy at TD Securities, said in a Bloomberg Television interview. “I don’t think the market was ready for this relief to be removed.”

As Credit Suisse Group AG’s Zoltan Pozsar put it this week, the Fed is “foaming the runway” to deal with the stress of going back to the leverage rule by giving banks an additional ability to direct deposits into money market funds. Fed officials said Friday that move was a monetarypolicy decision and not directly related to the leverage limit.

For the past year, that relaxed leverage cap had allowed the lenders to take on as much as $600 billion in extra reserves and Treasurys without bumping up their capital demand. The banks could now be under pressure to shed some of those assets or seek more capital.

JPMorgan has said it might consider turning away certain deposits as a result. And some Treasury market strategists expect a hit to the market as the biggest lenders potentially sell holdings.

Bank lobbyists and some market analysts argued that the Fed needed to keep the exemption in place to prevent banks from pulling back from lending and their critical role as both buyers and sellers of government bonds. But lawmakers and researchers who favor stricter bank oversight argued that the exemption would chip away at the protective cash buffer that banks had built up in the wake of the financial crisis, leaving them less prepared to handle shocks.

The Fed took a middle road: It ended the exemption but opened the door to future changes to how the leverage ratio is calibrated. The goal is to keep capital levels stable, but also to make sure that growth in government securities and reserves on bank balance sheets — a natural side effect of government spending and the Fed’s own policies — does not prod banks to pull back.

FEARS OF VULNERABILITY

The Fed said it would “shortly seek comment” on measures to adjust the leverage ratio. And it said it would make sure that any changes “do not erode” bank capital requirements.

“The devil’s going to be in the details,” said Jeremy Kress, a former Fed regulator who teaches at the University of Michigan. “I want to make sure any changes the Fed makes to the supplementary leverage ratio doesn’t undermine the overall strength of bank capital requirements.”

The temporary exemption had cut banks’ required capital by an estimated $76 billion at the holding company level, although in practice other regulatory requirements lessened that impact. Critics had warned that lowering bank capital requirements could leave the financial system more vulnerable.

Other banking regulators, like the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, took longer to sign onto the Fed’s exemption but eventually did.

Even though the exemption had been a tough sell in the first place, persistent worries over Treasury market functioning had raised the possibility that the Fed might keep it in place.

The government has been issuing huge amounts of debt to fund pandemic relief packages, pumping Treasury bonds into the market. At the same time, reserves are exploding as the Fed buys bonds and the Treasury Department spends down a cash pile it amassed last year. The combination risks filling up bank balance sheets. The fear is that banks will pull back as a result.