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U.S. Fed to let bank leverage exemption expire this month, will review rule

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March 19, 2021

By David Henry and Michelle Price

WASHINGTON (Reuters) – Big U.S. banks will have to resume holding an extra layer of loss-absorbing capital against U.S. Treasuries and central bank deposits from next month after the Federal Reserve said on Friday it would not extend a temporary pandemic regulatory break due to expire this month.

The Fed said it would, however, launch a formal review of the capital rule, known as the “supplementary leverage ratio,” due to concerns it is no longer functioning as intended as a result of the central bank’s emergency COVID-19 monetary policy measures.

While the Fed’s decision to review the rule is a win for Wall Street banks, which have long argued the leverage ratio is fundamentally flawed, its failure to extend the exemption, as many analysts had expected, came as a disappointment.

Shares of the largest U.S. banks dropped in pre-market trading immediately following the Fed’s announcement. By mid-morning, JPMorgan Chase & Co was down 3.4% and shares of Bank of America Corp were down 2.6% and Citigroup Inc were down 1.4%.

“Wall Street bank stocks will get punished because now they will have to put more money aside,” Edward Moya, senior market analyst at foreign exchange brokerage Oanda, said in an email.

He added, however, that the planned review of the leverage ratio “should alleviate concerns that this is a final decision.”

To ease stress in the Treasury market and to encourage bank lending as American households and businesses struggled amid lockdowns, the Fed last April excluded U.S. Treasuries and central bank deposits from the leverage ratio until March 31.

Uncertainty over whether the Fed would stick to that expiration date has added to recent anxiety in fixed income markets. Analysts and bank lobby groups have warned that allowing the rule to expire could push banks to pull back from government debt and lending more broadly, potentially sparking another bout of market turmoil.

The issue has become an unlikely political hot potato, with powerful Democrats pressuring Fed Chair Jerome Powell to deny Wall Street what they say is an unwarranted break given big banks have plenty of cash to buy back shares and issue dividends.

On Friday, Fed officials said they were confident that allowing the exemption to expire would not impair Treasury market liquidity or cause disruption because the Treasury market had stabilized and big banks have high levels of capital.

The U.S. 10-year Treasury yield rose slightly Friday morning to 1.7353%, indicating some initial concern over the news.

SURGING DEPOSITS, TREASURIES

The leverage ratio was adopted after the 2007-2009 financial crisis as an extra safeguard to prevent big banks from manipulating other capital rules. It requires them to hold additional capital against assets regardless of their risk.

But the ratio is rapidly becoming the primary limit on banks’ balance sheets which have swelled as a result of the Fed pumping cash into the economy amid the pandemic.

In the last year, the Fed has nearly doubled the size of its balance sheet to more than $7.7 trillion through the purchase of around $3.4 trillion in bonds. That extraordinary intervention along with near-zero interest rates aims to keep money flowing through the banking system.

As a result, bank deposits at the Fed, known as reserves, have sky-rocketed to $3.9 trillion since the pandemic began, according to Fed data from Thursday, and are expected to increase by another $2 trillion before the Fed pares back stimulus efforts.

“That pressure is pretty significant, and banks are going to have to optimize their balance sheets to deal with it, and part of that optimization may be stepping away from market supporting roles,” said Gennadiy Goldberg, interest rate strategist at TD Securities.

Banks say reserves and U.S. Treasuries effectively hold no risk and it makes little sense to penalize them.

Graphic: Bank reserves held at the Fed have skyrocketed – https://fingfx.thomsonreuters.com/gfx/mkt/yzdpxeqlkvx/Pasted%20image%201616161155027.png

The Fed indicated on Friday that it had heeded those complaints. Due to the continued growth in reserves and Treasury issuance, it said it may need to recalibrate the ratio “to prevent strains from developing that could both constrain economic growth and undermine financial stability.”

However, it added that any changes to the rule would not erode the overall strength of bank capital requirements.

While the Fed’s decision appears to be a neat compromise to appease both Wall Street and progressive Democrats, the rule review, which will be subject to public consultation, is likely to be a fraught and lengthy process, said analysts.

Progressives, who say Powell is inclined to be too friendly to Wall Street on regulatory issues, are generally skeptical of any attempt to crack open post-crisis rules and are likely to fight changes. That could leave the market in an uncomfortable limbo, said analysts.

“Unless there is a fix relatively quickly, I think there’s going to be a lot of caution in the market and a lot of concerns about volatility,” said Goldberg.

(Reporting by David Henry and Michelle Price; additional reporting by Noor Zainab Hussain, Karen Brettell, Pete Schroeder and Dan Burns; Editing by Andrea Ricci and Marguerita Choy)