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

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 pandemic monetary policy measures.

While the Fed’s decision to review the rule is a win for the banking industry, which has long argued the leverage ratio is fundamentally flawed, its decision not to extend the exemption, as many analysts had expected, will come as a disappointment.

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

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 cut back on government debt and from lending more broadly.

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

On Friday, Fed officials said they were confident that allowing the exemption to expire would not impair Treasury market liquidity or cause market 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 is a risk-neutral capital requirement adopted after the 2007-2009 financial crisis to prevent banks from manipulating other capital rules. But it is rapidly becoming the primary limit on banks’ balance sheets which have swelled as the Fed has pumped cash into the economy amid the pandemic.

Bank deposits at the Fed, also 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.

Banks say central bank 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 –

Due to the growth in reserves and Treasury issuance, the Fed indicated on Friday that it had heeded those industry complaints. It said that it may need to change the calibration of 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, a pledge that is likely to be met with skepticism by progressive Democrats who worry Powell is inclined to be too friendly to Wall Street on regulatory issues.

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