WASHINGTON — Federal Reserve Chair Jerome Powell signaled that regulators are weighing significant changes to a key capital requirement for large banks after market dislocations stemming from the pandemic revealed potential flaws in the measure.
The largest banks must maintain a minimum supplementary leverage ratio of 5% at the holding company level. A complement to risk-based capital requirements, the SLR assesses capital strength without risk differentiation for varying asset types.
The ratio effectively forces banks to set aside more capital for low-risk assets, which flooded the market last year when the Fed took action to respond to the COVID-19 crisis. Regulators took short-term action to ease the impact on financial institutions. But many said the recent market tremors made the SLR a "binding" requirement, which was never intended.
Powell appears to agree.
“When leverage requirements are binding, it does skew incentives for firms to substitute lower-risk assets for high-risk ones," he said in a press conference Wednesday after a meeting of the Federal Open Market Committee. "It's a straightforward thing."
The Fed eased the supplementary leverage ratio for large bank holding companies last year as the central bank responded to the pandemic by conducting large-scale asset purchases, which are still ongoing.
Banks could deduct Treasury securities and deposits held at the Fed from their calculation of the ratio to free up resources to make loans and absorb an influx of Treasurys. But the Fed let that temporary relief
However, the central bank said at the time that it would seek comment on ways to permanently adjust the SLR to account for the high growth in deposits. Banks argued the relief was, and continues to be, necessary to be able to s upport the economic recovery and ease strains in the Treasury market.
Although Powell declined to say when the Fed might request public comment on ways to permanently alter the leverage ratio, he noted that the requirement is not currently serving its desired purpose to backstop risk-based capital requirements. (The Fed would have to work with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency on changes to the SLR.)
“Because of the substantial increase in reserves, Treasurys and other safe assets in the banking system, the SLR is rapidly ceasing to be the intended backstop for big firms that we want it to be,” he said.
Powell added that, as a result, the Fed is still considering how to adjust the SLR to account for the high reserves. But he also said that the Fed would not endorse any adjustment that would have the effect of weakening capital requirements overall.
“We will take whatever actions are necessary to ensure that any changes we do make, or recommend, do not erode the overall strength of bank capital requirements,” he said.
Fed Vice Chairman for Supervision Randal Quarles
“Right now, the system can't hold the amount of cash that it has without a change,” Quarles said.
