With the Supplementary Leverage Ratio (SLR) rule going back into effect, rumors continue swirling that the banks will eagerly dump their Treasury holdings as the exemption to the rule encouraged them to buy Treasuries when they normally would have. Understanding how the SLR rule works, its intended purpose, and the current ratios are key to realizing the banks will not be selling any of their Treasury securities and likely buying more.
The SLR rule was designed to encourage banks to reduce their risky lending habits and to encourage them to purchase sovereign government debt instead. When banks take on deposits, they can lend out those deposits or purchase income-generating assets with them, such as Treasury securities, to generate a return on customer deposits.
The SLR rule, a part of the Basel III international banking regulations, encourages banks to reduce their balance sheets by purchasing sovereign debt over engaging in risky lending behavior that can lead to another financial crisis. The ratio is a bank’s Tier 1 Capital divided by their Total Leverage Exposure, which includes sovereign debt.
However sovereign debt is not weighted equally against other assets, such as commercial loans. Sovereign debt has a 0% risk weighting, while corporate debt has a 100% risk weighting, which by design, discourages banks from lending, and encourages them into reducing their balance sheets.
When a bank decides to lend, the SLR rule forces a bank to decide if it is worth the risk to lend money out over the guaranteed monthly dividends paid by U.S. Treasury securities. Whereas U.S. government debt has no default risk, lending comes with the potential of default. Since the SLR rule was implemented, banks have chosen to buy U.S. Treasury securities and tighten lending standards.
Large Global-Systematically Important Banks (G-SIBs) are the primary focus of the SLR rule and instead of the normal 3% target, G-SIBs have a minimum 5% target for the ratio with an ideal target of 6%. Again, this higher target was designed to reduce the balance sheets of the largest G-SIBs to reduce the potential of another financial crisis.
When the pandemic hit, and corporations were desperate to access their large credit lines, the Federal Reserve was worried a large increase in borrowing would negatively impact the bank’s SLR ratio as a large increase in borrowing would increase the denominator and potentially push the ratio below the minimum target. To alleviate any concerns, the Fed exempted Treasury securities and deposits held at the Federal Reserve member banks to give the banks plenty of room to lend without worrying about their SLR ratio.
Banks took advantage of the SLR exemption and engaged in exactly the type of behavior the SLR rule was intended to discourage, by extended massive credit lines to investors. Investors eagerly took advantage of this credit by using it to speculate on risk assets. As risk assets rose, so too did those credit lines, which generated the bank’s tens of billions of dollars in revenue when most corporations were struggling.
As this credit-fueled stock market went higher, investors and speculators looked elsewhere for more ammunition. They turned to the bond market and began shorting Treasuries to get more cash. When investors short bonds, they borrow a bond from a securities dealer, which creates a copy of the original bond, that is then sold on the open market. The proceeds are then used to buy more risk assets to perpetuate the bubble.
The flood of Treasury securities hitting the market from the government issuing large amounts of debt to get the economy back on track and speculators shorting Treasuries was too much for the market and the Fed to absorb. Yields rose, which encouraged investors to pile on the short side.
Since the banks were profiting handsomely from the SLR exemption, it was only natural they would want it to continue for a while longer as investors showed no desire to slow down their attempt to bid stock prices higher. Despite attempts by the banks to convince the world this exemption was the only thing keeping Treasury yields from going even higher, the Fed stated last week the exemption would expire as scheduled.
The announcement by the Fed spurred even more speculation the banks would be forced to sell Treasury securities as they would want to hold onto these more profitable risky loans to avoid falling below the minimum SLR ratio target. So far, not one bank has announced it will be cutting its dividend or share buyback program due to the expiration of the SLR exemption, suggesting the banks will meet the SLR minimum after Treasury securities and deposits held at Federal Reserve banks are added back into the formula.
The expiration of the SLR exemption should not have a significant impact on the G-SIBs SLR ratio that would lead to massive selling of Treasury securities. This was validated by Zoltan Pozsar, the Managing Director at Credit Suisse who wrote a report just before the Fed’s announcement stating that the expiration of the SLR exemption is unlikely to cause any banks to sell any of their Treasury securities.
The likely outcome of the expiration of the SLR exclusion is banks will start tightening standards on investor’s margin accounts and reigning in corporate credit lines. Increasing margin requirements will likely put an end to this speculative bubble in stocks as there will be little fuel to continuing pumping stock prices higher after the stimulus checks are spent.
As far as Treasury yields, they are likely to head lower as banks take advantage of higher yields by adding Treasury securities as they reduce the amount of riskier credit they have extended since the SLR exemption gone. Given the economy is in a fragile state and unemployment remains high, the banks are going to focus on making sure they get their money back, which is their highest priority when lending money out.
The SLR rule was intended to reduce the size of bank balance sheets by discouraging lending and by encouraging the purchase of sovereign debt. With Treasury yields up and bond prices down, Treasury securities will be very attractive to banks, especially as they seek to squeeze the short-sellers out.
With the help of the Fed, which continues to purchase $10.5 billion of 30-year Treasury bonds per month, it will not require much effort on behalf of the banks to begin squeezing these sellers of Treasuries out. Without the infinitely expanding credit lines due to the SLR exemption, Treasury sellers will find themselves being forced into selling stocks to cover their Treasury short positions.
Over the next several months, the direction of bond prices is likely to make a rapid move higher as without the SLR exemption, speculators will not have an infinite supply of new money and banks will be looking to profit on lower bond prices. Without an endless supply of new dollars from ever-expanding credit lines, the dollar should also rally which is very bond bullish.