Wall Street wants capital rules eased to unblock $22tn Treasury market

Wall Street analysts and lobbyists are calling for the Federal Reserve to ease capital requirements to improve liquidity in the $24tn Treasury market as part of an ongoing review of rules governing the nation’s largest banks.

The market for US government debt is considered the safest in the world, in part because of the ease with which traders can buy and sell bonds. That liquidity, however, has deteriorated in recent years as banks have pulled back from their traditional market-making roles. A Bloomberg index measuring liquidity in the Treasury market hit its worst levels in late 2022 since the market shock of March 2020.

Banks have long argued that reducing their capital requirements by exempting Treasuries and cash reserves from calculations of their so-called “supplementary leverage ratios” (SLR) would allow them to participate more in the market.

A “holistic” review of the banking system’s capital rules by the Federal Reserve’s new vice-chair for supervision, Michael Barr, offers the potential for such reform some time in 2023. Some experts warn any easing on that front is likely to be accompanied by an increase in capital requirements elsewhere, a solution unlikely to please banks.

Mark Cabana, head of US rates strategy at Bank of America, said: “Any way regulators can stimulate demand would benefit the Treasury market. We don’t know if SLR reform will come next year, but we would support it.”

After the spectacular collapse of the banking system during the 2008 financial crisis, regulators demanded lenders hold more cash on hand and also boost equity capital. The SLR requires large banks to have capital equal to at least 3 per cent of their assets, or 5 per cent for the largest, systemically important institutions.

There is evidence that these rules have been effective: banks made it through the Covid-19 crisis relatively unscathed. But Treasury market functioning has suffered as lenders pulled back in the past decade, including during the March 2020 market meltdown when high-speed traders — who have stepped in to replace banks since 2008 — pulled back from market-making.

“With higher capital requirements, you have less balance sheet that you can allocate to market-making,” said Joseph Seidel, chief operating officer of the securities’ industry group Sifma.

Greg Baer, the chief executive of the Bank Policy Institute, another lobbying group, echoed that sentiment: “The SLR has obviously been a puzzler for years. Every market participant and analyst seems to think [change] would help market liquidity — some a lot and some a little bit, but no one zero.”

It is not just banks and their lobbyists making the argument. Experts in Treasury market regulation and in financial stability have warned of the consequences of neglecting Treasury market functioning. “[SLR relief] arguably incentivises, or at least makes it easier for primary dealers to justify diverting their capital to Treasuries market-making,” said Yesha Yadav, a professor at Vanderbilt Law School who studies Treasury market regulation.

Andrew Metrick, a professor at Yale’s School of Management whose research focuses on financial stability, emphasised the risk-free nature of cash reserves and Treasuries. “Even if we’re going to have a leverage ratio, it seems to me that government liabilities really don’t belong in any kind of measure of bank riskiness.”

One major caveat, however, is that the Fed temporarily exempted reserves and Treasuries from the standard leverage ratio in the wake of the March 2020 meltdown, in hopes of encouraging banks to participate more in the market. The experiment was only modestly successful — the changes to market-making activity and balance sheets were not dramatic — and the exemptions generated considerable unease among progressive lawmakers.

At a congressional hearing in November, Barr, who assumed his position in July, acknowledged heightened volatility in the Treasury market and said the Fed is “attentive” to liquidity concerns. However, he made clear that he does not expect adjustments to current capital requirements to have too much of an impact.

“If you rank-ordered the list of reasons for Treasury market liquidity constraints right now, it’s probably relatively low on the list,” he told US lawmakers. SLR is part of his broader review, however, leading some to hope that changes may be on the way.

Gennadiy Goldberg, a rates analyst at TD Securities, said: “Barr has also said that any change in US law has to be weighed against market liquidity concerns. And the fact that was mentioned specifically gave me a little bit of hope that they may slightly ease the SLR to help improve market liquidity.”

One compromise regulatory experts expect to potentially garner support is for bank reserves held at the central bank to be exempt from SLR calculations — an idea Nellie Liang, who serves as under-secretary for domestic finance at the Treasury department, has previously endorsed.

“On the progressive side, there probably won’t be as much fight over reserves, because they really, truly are riskless,” said Jeremy Kress, a former lawyer in the banking regulation and policy group at the Fed who is now at the University of Michigan. “With Treasuries, you still have some residual [risk] that you might want to maintain capital for.”

Any change to the SLR would probably be accompanied by tougher rules elsewhere. In remarks delivered in early December, Barr noted US capital requirements “are toward the low end of the range” of what is typically considered optimal.

Ian Katz, financial policy analyst at research firm Capital Alpha Partners, said: “Anything they do that might appear to be helpful to the banks will be more than outweighed by what he [Barr] does that the banks aren’t going to like.”

The expectation among lobby groups is for the government to hold off on making any changes to bank capital until policymakers first settle on the implementation of the so-called Basel endgame rules. The new Basel rules represent the global minimum standards for bank capital requirements and are designed to make lenders more robust during financial stress. Lobbyists hope plans for the final implementation of the rules in the US could be published in the first six months of 2023.