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The market is now focusing on Fed’s next meeting on 17th Mar, whether the U.S. Central Bank expressed any intention for Operation Twist 3.0 and SLR extension for banks. As a pointer, the primary reasons behind the recent rise in bond yields are the gradual normalization of the economy to pre-COVID levels, the concern of higher inflation/reflation as a result of huge COVID stimulus as-well-as the suspense over SLR exemption extension after Mar’21.
The SLR (Supplementary Leverage Ratio) is the U.S. version of BASEL-III capital adequacy norm and a Tier-1 leverage ratio; it varies from 3-5% common equity capital U.S. banks must maintain relative to their total leverage exposure. This is like a backstop to risk-weighted capital requirements. If the SLR exemption is not extended beyond Mar’21, big U.S. banks (which are one of the biggest holders & market makers of USTs), may be forced to liquidate a significant portion of their UST holdings in the secondary market (to reduce leverage exposure) that may cause another wave of the plunge in bond prices and bond yield will soar further.
As per some estimates, eight big U.S. banks (systematically important; too big to fall category) now hold around $2T USTs and they may be forced to liquidate around $350-550B if SLR is not extended. The SLR exemption extension may be the main reason behind the sudden surge of bond yields in the last few days as neither Powell nor any other concerned regulatory official signaled so far that it would be extended (directly/indirectly) after the Mar’21 expiry.
The FDIC Chair McWilliams said last week it doesn’t seem like banking agencies need to extend the SLR, which was exempted in April’20 (after COVID) as an emergency move/tool that made it cheaper for insured depository institutions (banks) to hold cash and U.S. government bonds on their balance sheets. The FDIC kicked the can towards Fed: “The most important question rests with the Federal Reserve--That’s because capital requirements for the parent holding company, which is regulated by the Fed, are more important for determining how expensive it is for those banks to hold Treasuries”.
As a pointer, back in April’20 after the UST/funding/money market has frozen (COVID lockdown), U.S. banking regulators led by Fed, FDIC (Federal Deposit Insurance Corporation), and OCC (Office of the Comptroller of the Currency) eased the SLR requirements. The SLR rule was imposed after 2008 GFC and it requires large U.S. banks to have capital equal to at least 3% of their assets, or 5% for the largest, systemically important institutions/banks (such as JPM, BOA, CITI, GS, WF and MS).
Under the SLR exemption benefit, U.S. banks were allowed to temporarily exclude holdings of UST and cash kept in reserve at the Fed from their assets when calculating the ratio. This has allowed big U.S. banks to have higher UST holdings without the requirements of higher capital correspondingly. Also, during COVID lockdown, people saved more in banks rather than spend and thus deposit levels are also high, leading to a higher requirement of SLR.
Now, although U.S. banks are now lobbying intensely to extend the SLR exemption at least till another year (or even permanently) till there is substantial economic recovery and ease of public savings, both Fed and FDIC are non-committal, although the last-minute surprise by Fed maybe not ruled out. Alternately, apart from selling some USTs, banks may also raise capital, which hurts EPS/ROE. Banks may also refuse fresh deposits for the sake of SLR. The SLR exemption made it easier for banks to facilitate trading in USTs; take in extra deposits from customers who cut spending during the lockdown, and extend credit to companies facing a COVID cash crunch.
Although so far Powell is silent, back in Oct’20, Fed’s vice-chair for banking supervision Quarles said the SLR change was ‘temporary’ and there was no current discussion around ‘making it other than temporary’. Fast forward, last week, U.S. Democrat Senators Warren and Brown urged U.S. banking regulators to reject bank’s appeals to extend the SLR exemption.
In a joint letter to the Fed, FDIC, and OCC, Democrats Warren and Brown (known policy hawks and chairs of the Senate Banking Committee) argued that the banking industry is taking advantage of the COVID crisis to weaken one of the most important post-GFC regulatory reforms and granting the extension would be a fatal error.
Warren and Brown wrote in a joint letter:
“Dear Chairman Powell, Vice Chair Quarles, Chairman McWilliams, and Acting Comptroller Paulson:
We write to ask that you reject the coordinated lobbying efforts of the country’s largest banks to convince your respective agencies to extend a temporary rule that reduced banks’ capital requirements. This temporary rule substantially weakens one of the most important regulatory requirements for large banks put in place after the 2007-2008 financial crisis; You should restore those requirements as quickly as possible.
On April 1, 2020, the Federal Reserve Board of Governors (Fed) released an interim final rule (IFR) that allowed bank holding companies to exclude U.S. Treasuries and deposits held at Federal Reserve Banks from the calculation of their Supplementary Leverage Ratio (SLR) through March 31, 2021. The Fed, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) subsequently released a joint IFR allowing insured depository institutions to opt-in to this capital carve out.
This change resulted in a $55 billion reduction of capital requirements for the largest banks. The stated rationale for this change was to allow banks to “expand their balance sheets as appropriate to serve as financial intermediaries and serve their customers.” The pandemic induced flight to liquidity by investors and corporations resulted in increased bank deposits and bank demand for safe assets like reserves and Treasuries.
Regulators indicated that the increase in reserves in the banking system as a result of actions taken to support market functioning during COVID-19, and the influx of customer deposits, would put pressure on banks’ balance sheets. Specifically, the IFR noted, “the resulting increase in the size of depository institutions’ balance sheets may cause a sudden and significant increase in the regulatory capital needed to meet a depository institution’s leverage ratio requirement”.
The IFR was nominally written to help banks address these – presumably temporary – restraints. But in reality, the relief went well beyond this simple accommodation, exempting all Reserve Bank deposits and Treasury Securities from the calculation, including those that banks held well before the crisis. Moreover, it is not at all clear that the rule helped support businesses and households. Recent data suggests that big banks are committing an ever-decreasing portion of their balance sheets to business and household lending: the share of banks’ assets devoted to loans is now at a 36-year low.
On June 19, 2020, we wrote to your agencies to express our strong opposition to the IFR. The responses we received from Vice Chair Quarles and Chairman McWilliams both confirmed that the exclusion will expire on March 31, 2021.
But recent reporting from the Financial Times indicated that “the banks and industry representatives had been in talks with the Fed to extend the exemption beyond March.”12 It is unclear whether the OCC and the FDIC are engaged in similar discussions.
Extending this exemption from capital requirements at either the bank or holding company level would be a grave error. While employment has largely recovered for the highest-paid workers, employment remains down 17 percent for the lowest-wage earners since last February, and small businesses across the country are still struggling. Additionally, the most recent minutes of the Federal Open Market Committee noted that financial stability risks remain “notable,” citing “vulnerabilities associated with household and business borrowing…reflecting increased leverage and decreased incomes and revenues in 2020.”
Banks’ balance sheets will also likely continue to face pressure from loan defaults in the coming months. During the last three recessions, banks’ loan losses did not peak until at least a year after the start of the recession. Reducing banks’ capital reserves needed to absorb these potential losses could result in significant risks to banks and the stability of the financial system.
Indeed, there was ample evidence before the COVID-19 shock that big bank capital, while improved since the last crisis, was still too low to support long-term sustainable economic growth. The banks’ requests for an extension of this relief appear to be an attempt to use the pandemic as an excuse to weaken one of the most important post-crisis regulatory reforms.
To the extent there are concerns about banks’ ability to accept customer deposits and absorb reserves due to leverage requirements; regulators should suspend bank capital distributions. Banks could fund their balance sheet growth in part with the capital they are currently sending to shareholders and executives. We are also confident that the thousands of community banks that are not subject to the SLR requirements would be happy to accept deposits that large banks may reject.
It is inexcusable to provide Wall Street with deregulatory capital exemptions while allowing them to pay out tens of billions in the capital every quarter through dividends and stock buybacks. Those capital distributions could instead be used to support over a trillion dollars in balance sheet growth.
You and your predecessors at your independent regulatory agencies succumbed to political pressure to weaken these key reforms, creating new risks for the economy and the financial system. You now have the opportunity to rectify these errors and restore bank capital requirements, and you should do so”.
Overall, Warren, a known policy hawk for Wall Street is concerned about the long-term financial stability objective due to the relatively lower capital adequacy ratio of big U.S. banks as a result of SLR exemption. Banks are also vulnerable to potentially higher NPA/NPL in the coming days as a result of COVID disruptions.
On late Friday, the U.S. Treasury Secretary Yellen downplayed higher bond yields by pointing out as a sign of economic recovery to pre-COVID levels amid progress of COVID vaccinations/herd immunity, huge fiscal stimulus/CARES Act 3.0/infra stimulus, and not inflation. Although Fed has various tools to cool off any unwanted higher inflation, Yellen strongly believes that Fed doesn’t have to use it as inflation may hover around 2% range, not significantly higher than 2% by Dec’21:
Well, I don't see that the markets are expecting inflation to rise above the 2 percent objective that the Fed has as an average inflation rate over the longer run. Long-term interest rates have gone up some, but mainly, I think, because market participants are seeing a stronger recovery, as we have success with getting people vaccinated and a strong fiscal package that's going to get people back to work. And, of course, the Fed does have tools to address inflation if it becomes a problem. But I don't believe — I don't believe it will. And I don't see markets or most forecasters worrying about that.
I think they're (rising bond yields) a sign that the economy is getting back on track, and that market participants see that, and they expect a stronger economy. And instead of inflation lingering below levels that are desirable for years on end, they're beginning to see inflation get back to a normal range, around 2 percent.
There is immense political as-well-as regulatory pressure on Fed/Powell to restore the SLR requirements. The Fed also owes a proper explanation of the UST/funding market freeze back in late Mar’20 (COVID lockdown), which prompted the U.S. Central Bank to go for SLR exemption, unlimited QE launch, and various other emergency lending/liquidity tools u/s 13A with Treasury backstop. The Fed had even launched QE-Lite even before COVID due to money market tightening and USD shortage (as a funding currency). As per various reports, some big U.S. banks virtually forced Fed to act by alleged collusion/collective effort by not acting as proper market makers or lending each other.
Now if Fed does not extend SLR, there may be some additional selling of USTs around $350-550B in the secondary market, which either Fed has to absorb by announcing targeted QE buying to ensure easy financial conditions (like ECB’s targeted PEPP within the overall envelope) or some foreign buyers must step in (China, Japan, and EU).
Overall, Powell (Fed) and Yellen (U.S. Treasury) is still comfortable about 2% inflation (core PCE) and 2% bond yield:
The market was expecting that Powell may signal Operation Twist 3.0; i.e. the Fed will shift its QE purchases to the long end from the present short end to bring down the benchmark 10Y UST yield. The market is also concerned that Fed may be increasingly losing control over the bond yield curve, a vital factor to ensure its policy rate through the economy. The Fed is simultaneously losing control of both the U.S. front end and back end rates curves for various reasons, resulting in bond yield curve steepening and higher borrowing costs for the real economy. The market was also expecting Powell may signal SLR relief for banks, easing a big reason behind the recent bond market volatility.
But Powell disappoints on both and virtually acknowledged higher inflation in the coming days as the economy will open fully, while Powell now looks less confident on the transitory nature of such inflation. And Powell sounds that he/Fed is not concerned about a higher bond yield around +2.00%.
Considering Biden’s total fiscal stimulus of around $6T (CARES Act 3.0 for $1.9T and infra stimulus $4T) over the next 5-10 years and projected U.S. bond yield/coupon rate around 1.75-2.00%, the U.S. will pay around 15% of its revenue towards debt interest payment (assuming elevated interest on full $32T debt and no significant rise in tax revenue).
But in reality, due to the rollover of existing debt at a cheaper rate and likely rise in tax revenue due to huge fiscal stimulus and higher economic activities, the interest/revenue should be around 10-12%, which would be comfortable considering all factors. Although a 15% debt/revenue ratio would be uncomfortable, even that is not a big factor for debt addicted ‘Uncle Sam’ (America).
As the U.S. may achieve herd immunity (COVID) by H1-2022, Fed may start its gradual QE tapering from Dec’22 and rate hikes from Dec’23. The market is now apprehending that Fed may allow elevated/attractive bond yields (say around +2.00%) to attract angel investors; otherwise, who is going to fund the ‘America Rebuild’ story?
And thus Fed may not extend COVID time SLR exemption further beyond Mar’21 for the sake of financial stability (bank NPA) and as Biden admin is comfortable with slightly higher bond yields/borrowing costs. But at the same time, Biden also needs ultra-low borrowing costs to fund his COVID stimulus including infra and thus Fed may also extend the SLR for another year (till Mar’22) to fund Biden’s CARES Act 3.0 and infra stimulus at lower possible borrowing costs. By Mar’22, the U.S. may be also able to flatten its COVID curve significantly, paving the way for almost normal economic activities and Fed normalization.
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