Big banks get Fed's blessing to extend leverage amid market stress

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The Federal Reserve will let Wall Street banks take on more leverage so they can absorb a severe lack of liquidity for Treasuries and a surge in customer deposits amid the coronavirus pandemic.

A key limit on big banks’ indebtedness — the so-called leverage ratio — will be temporarily relaxed with lenders getting “significant inflows of customer deposits,” the Fed said in a Wednesday statement. For one year, the biggest U.S. banks will no longer have to add their Treasuries and reserves into the basket of assets they’re required to maintain capital for — significantly reducing capital requirements.

With this week's revision on liquidity rules, banks such as JPMorgan Chase will be allowed to function as giant custody banks like Bank of New York Mellon and State Street.
With this week's revision on liquidity rules, banks such as JPMorgan Chase will be allowed to function as giant custody banks like Bank of New York Mellon and State Street.

In its statement, the Fed was clear that the move was meant for banks “to expand their balance sheets as appropriate to continue to serve as financial intermediaries, rather than to allow banking organizations to increase capital distributions.” The Fed added that it made the decision because “liquidity conditions in Treasury markets have deteriorated rapidly.”

The change — effective immediately — will reduce capital demands by about 2% overall, the Fed estimated, and will be open for a 45-day comment period. The unanimous decision got the backing of Fed Gov. Lael Brainard, who hasn’t supported other recent agency decisions to overhaul regulations put in place after the 2008 financial crisis.

The leverage ratio is one of the most fundamental limits implemented in response to the last meltdown. It’s meant to be a very simple calculation of each bank’s capital against all its assets. The requirement functions in tandem with the other big capital constraint on banks — a cushion based on the riskiness of the lender’s assets.

“Leverage ratios are especially a problem in a crisis when large bank balance sheets grow as investors move out of riskier assets for the safety of a bank deposit,” Jaret Seiberg, a policy analyst for Cowen Washington Research Group, wrote in a note.

The disruption in Treasury markets threatened to prevent Wall Street banks from executing transactions the Fed wants them to amid the current tumult, including funding short-term borrowing arrangements known as repurchase agreements. By not counting Treasuries in their leverage ratios, banks should have more ability to provide such financing.

After the Fed’s announcement, benchmark 10-year yields fell by 4 basis points to 0.57% before slightly paring the move. Treasuries remained richer by 8.6 basis points on the day. The gap between two- and 10-year yields re-flattened to almost the tightest levels of the day.

“This frees up balance sheet capacity, particularly for leverage constrained banks, allowing them to engage more in balance sheet intensive activities like repo intermediation and market making in Treasuries,” said Credit Suisse strategist Jonathan Cohn. “By making those activities less costly, intermediaries will be better able to step in when there are one sided flows.”

With Wednesday’s revision, bank holding companies such as JPMorgan Chase and Citigroup will function like the giant custody banks — Bank of New York Mellon and State Street — which were already granted this exemption.

When Congress moved to ease up on custody banks’ leverage calculations, it drew criticism from consumer advocates who said such massive, vital institutions need to maintain stringent protections.

The rule change automatically reverts on March 31, 2021. The Fed’s statement suggested it plans to administer the temporary revision in a way that ensures the banks won’t take advantage of it.

Though the Office of the Comptroller of the Currency also has significant authority in enforcing the leverage ratio, it didn’t join the Fed Wednesday in announcing the move. An OCC spokesman said he couldn’t comment on the regulator’s potential future actions.

Bloomberg News