The Fed is scaling back one of its unprecedented relief measures. In this article we cover what it is, the impacts from the COVID-19 crisis, and the outlook moving forward. Ultimately we ask one important question, has the Federal Reserve's actions contradicted the purported purpose of one of its most important financial measures?
Background
The Basel Committee on Banking Supervision (BCBS) is a committee established in 1974 by the Bank for International Settlements (BIS), which is the oldest international financial institution. After the 2008 financial crisis, the the BCBS created the Third Basel Accord also known as Basel III. Basel III is a global voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. The Federal Reserve would implement a modified version of this framework in the US. One of the measures created under this framework, is the supplementary leverage ratio (SLR). Per the Revised Basel III leverage ratio framework and disclosure requirements, this ratio's purpose is to "restrict the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that can damage the broader financial system and the economy". Its calculation is as follows:
Tier 1 capital is generally defined as consisting of a bank's common stock and disclosed reserves (or retained earnings). Total leverage exposure includes on-balance sheet exposures, derivative exposures, repo-style exposures, and other off-balance sheet exposures. The following graphics from Deloitte are a good visual representation of total leverage exposure and the SLR calculation:
The SLR minimum threshold is based upon the banks assets or on-balance sheet foreign exposure. U.S. SLR institutions are defined as banking organizations with total consolidated assets greater than or equal to $250 billion or on-balance sheet foreign exposures greater than or equal to $10 billion. U.S. eSLR institutions are defined as banking organizations with total consolidated assets greater than or equal to $700 billion or assets under custody greater than or equal to $10 trillion. U.S. SLR institutions are required to maintain a minimum ratio of 3%, while eSLR institutions are required to maintain a minimum ratio of 3% plus a buffer or add-on amount. See another Deloitte visual below that shows SLR requirements for Bank Holding Companies (BHC) and Insured Depository Institutions (IDI):
The Crisis
Following the beginning of the 2020 COVID-19 pandemic and the associated disruptions in the financial markets, the Board of Governors of the Federal Reserve System announced a temporary change to its SLR rules to ease strains in the Treasury market. These temporary changes essentially excluded Treasuries and deposits held at Federal Reserve banks from the denominator of the SLR , which would increase the leverage exposure capacity of banking organizations.
The Brookings Institute has a great article summarizing the issues in the Treasury market and how the Federal Reserve addressed them here. Some insightful quotes from this article are below:
As one of the world’s most heavily traded assets, Treasuries should have been easy to sell. But a lot of other market participants were trying to sell amid the uncertainty about COVID-19: asset managers were seeking to raise cash to meet redemptions; foreign central banks were selling Treasuries to acquire dollars to manage capital outflows and exchange rates; banks needed to fund draws on their revolving corporate credit facilities; and investors were selling to rebalance their portfolios after the sharp fall in equity prices. Though there were clearly many buyers, there were not enough to meet this supply. Whereas in the past dealers would warehouse the excess until a match could be made, they ran up against a difficult combination of regulatory constraints on the size of their portfolios and extreme price fluctuations even over short time periods. This was worsened by the fact that the bonds being sold were predominantly off-the-run, another source of volatility that dealers struggled to manage. Extreme price fluctuations led to additional illiquidity.
The bold emphasis in the quote above was added by me. One more additional quote from Brookings Institute below:
At the same time as Treasury investors were trying to raise cash, corporations were trying to build cash buffers to help ride out the economic storm. But by crowding out other essential forms of lending, the disruption in Treasury markets sharply limited their ability to borrow in capital markets. Many companies tapped their bank revolving credit lines, which eventually would have led banks to sell their high-quality liquid assets (including Treasuries) to fund those draws, accelerating a vicious cycle of deleveraging.
Again, the bold emphasis in the quote above was added by me. The COVID-19 pandemic created additional volatility in the Treasury market as consumers and businesses took on bank debt to ride out the crisis. This increased many bank's total leverage exposure (the denominator) and negatively impacted the SLR and many banks now needed to deleverage. Due to these circumstances, banks were forced to sell off their Treasuries to keep their SLR in check and fund bank credit withdrawals from businesses and consumers. This caused a sudden rise in the 10-year Treasury yield as can be seen in mid-March in the graph below:
This sharp spike in yields was one of the primary factors for the Fed's April 1, 2020 announcement to exclude Treasuries from the denominator of the SLR. By excluding Treasuries, which are theoretically risk-free assets, banks were better able to meet the minimum SLR requirement and would be less likely to need to sell off their Treasuries. By the time the Fed made this announcement, the 10-year Treasury yield had already restarted its downward trend. This is more than likely due to the Fed relaunching a massive and unlimited QE program to buy-up US Treasuries and other assets. The overall yield change was probably less of a concern than the volatility. The graph below shows the 10-year Treasury Note Volatility Futures, which shows a tripling in the index value during March 2020. Between unlimited QE, softening leverage regulations, and fiscal stimulus, the financial markets were numbed and quelled.
The End of the Crisis?
Nearly a year later and the crisis looks to be winding down. Vaccines have rolled out, lockdowns are beginning to end, and the impact of COVID-19 is starting to dissipate. The Fed's announcement to exclude Treasuries and bank deposits held at the Federal Reserve from the SLR had an expiration date of March 31, 2021. The question now was, "will the Fed extend the SLR relief provision temporarily or permanently?" The Fed announced that they would let the SLR provision expire on March 31, 2021 as originally intended. Banks and other financial institutions will need to adjust their balance sheets to ensure that they meet the pre-crisis SLR framework. The US 10-year Treasury yield has already significantly risen since hitting its low of 0.52% in August 2020. The yield is almost back to pre-COVID-19 levels and the expiration of the SLR relief provision could further accelerate yields higher.
Inflation and the Future
Rates have been rising for a few different reasons, but primarily due to increased growth and inflation expectations. Professor Aswath Damodaran created a fantastic video on the subject and its impact on equity prices. With the world on the cusp of returning to some degree of normalcy, growth expectations are ever increasing. The combination of fiscal stimulus, monetary stimulus, and pent-up demand is causing growth expectations to shoot higher. Inflation is also steadily increasing as suppliers are still struggling to recover from pandemic lockdowns and meet the surging demand of "stimmied" consumers. The Fed has long been targeting 2% inflation and has usually fallen well short of this goal. Now it looks like inflation finally has the potential to exceed the 2% target and the Fed is currently unworried. From a March 2021 CNBC article on the Fed:
Expectations for core inflation moved higher, with the committee now looking for a 2.2% gain this year as measured by personal consumption expenditures. That is estimated to fall to 2% in 2022 and then edge higher to 2.1% the following year, with the long-run expectation at 2%.
As to how those improvements will move the needle on policy, the committee still expects benchmark interest rates to remain unchanged through 2023.
Fed Chairman Jerome Powell said he expects that inflation will rise this year due in part to soft year-over-year comparisons from the early days of the Covid-19 pandemic in early 2020. However, he said that won’t be enough to change a policy that seeks inflation above 2% for a period of time if it helps to achieve full and inclusive employment.
“I would note that a transitory rise in inflation above 2% as seems likely to occur this year would not meet this standard,” Powell said.
The Bold emphasis in the quote above is added by me. Once the inflation genie is out of the bottle, can it be tamed? The Fed historically hasn't been successful in hitting its 2% inflation target; if needed, will they be just as successful in reducing inflation? Even with all of the Fed's prior monetary experiments over the last decade plus, they have avoided significant inflation. If faced with significant inflation and an economy built on ultra-low interest rates, what does the Fed do? Save the currency or crash the biggest bubble economy in history?
Both increasing growth and inflation expectations will continue to push longer term rates upwards. The expiration of the SLR relief will only further accelerate this trend, although it should only have a temporary impact. As previously mentioned, the SLR's purpose is to "restrict the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that can damage the broader financial system and the economy". The Federal Reserve adjusted the SLR policy to enable the banking system to increase its leverage capacity. Now with the expiration of the SLR relief provision, can the US economy avoid a potentially destabilizing deleveraging process? Has the Federal Reserve's SLR policy created a situation that is in the antithesis of its purpose?
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