Under the Macroscope: Why cutting the SLR matters

On Wednesday, June 25, the Federal Reserve (Fed) made an important announcement regarding bank capital requirements with potential significant implications for US fixed income market liquidity. In what follows, we explain why trimming the Supplementary Leverage Ratio (SLR) will improve market liquidity, even if it does not have a significant impact on market yields.

Specifically, the Fed published a proposed change to the SLR, which requires US-regulated big banks to hold additional capital, including for market-making purposes. The Fed’s proposal would reduce the capital requirement for bank holding companies and banking subsidiaries to a range of 3.5%–4.5%, down from the current rates of 5% for banking holding companies and 6% for banking subsidiaries. The Fed’s proposal will now enter a public comment period. Interested readers can find the full document here (Draft Notice).

The current SLR levels have disincentivized banks to some extent from holding Treasury bonds, including for intermediation purposes. US Treasury market liquidity has historically been fickle—especially during periods of market stress. Accordingly,  an amendment to the SLR has long been seen as a likely and necessary step to ensure appropriate liquidity in the vast market for US Treasury securities.

In our opinion, the Fed’s proposal is a move in the right direction, as it would allow primary dealers to better intermediate in the Treasury market. Continuous liquidity in what investors at large consider the world’s largest and safest asset class is an unalloyed “good,” we believe, and a more liquid Treasury market will also help the US federal government to fund its ongoing budget deficits. As a result, the Fed’s proposal ought to be seen as positive for US government bonds.

At the same time, we think the move will probably have only a modest impact on bond prices (and hence yields). First, the change—as noted—is not a surprise. Fed Governor Michelle Bowman has long argued for a reduction in the SLR, and once she became Vice Chair for Supervision at the Board of Governors, many observers anticipated a policy shift in this direction. Second, US banks currently do not appear to have significant interest-rate risk capacity, insofar as they already have significant Treasury holdings. With a relatively flat yield curve,¹ their incentive to buy long-dated Treasuries is currently limited. A steeper curve would, however, make such purchases more attractive.

Accordingly, banks may now be more inclined to absorb more shorter-dated Treasuries to cap their duration risk. That is also what market pricing suggests. Swap spreads, which can serve as a gauge of relative demand for physical Treasury bonds versus synthetic exposure via derivatives, suggest a muted response thus far.

A final point is also worth noting. In its memorandum, the Fed estimates that the proposed changes would reduce aggregate capital requirements by US$13 billion. This modest reduction in capital requirements reflects the fact that more capital will be retained within the consolidated holding companies. If so, the reduction in the SLR could lead to additional (leveraged) Treasury purchases in the range of hundreds of billions of dollars, but not trillions, as some have suggested. Holding companies may also dedicate some of that additional purchasing power to other fixed income market segments as well.

All in all, the proposed reduction in the SLR marks an important step in the direction of ensuring continuous liquidity in what is the world’s largest and generally seen as the safest asset class. We believe that is an unambiguous positive for capital market participants. We believe it would be wrong to conclude, however, that the proposed SLR reduction will unleash a surge in Treasury purchases. The impact on bond prices and yields is likely to be more modest.