WASHINGTON (Reuters) – Big U.S. banks will have to start holding an extra layer of loss-absorbing capital again against U.S. Treasuries and central bank deposits from next month after the Federal Reserve announced on Friday that it would not extend a regulatory hiatus in the event of a temporary pandemic that expires this month.
The Fed has said, however, that it will launch a formal review of the capital rule, known as the ‘additional leverage ratio’, over fears it will no longer work as expected due to the emergency monetary policy measures. COVID-19 from the central bank. .
While the Fed’s decision to review the rule is a victory for Wall Street banks, which have long argued that the leverage ratio is fundamentally flawed, its refusal to extend the exemption, as many analysts had predicted. , was a disappointment.
Shares of the largest US banks fell after the news, with JPMorgan Chase & Co losing as much as 4% before closing down 1.6% on the day. Bank of America Corp and Citigroup Inc lost 1% and 1.1% respectively.
“The actions of Wall Street banks will be punished because they will now have to put more money aside,” Edward Moya, senior market analyst at the exchange firm Oanda, said in an email.
He added, however, that the planned leverage ratio review “should alleviate concerns that this is a final decision.”
To ease tensions in the Treasury market and encourage banks to lend to struggling Americans amid a freeze, the Fed last April excluded Treasuries and central bank deposits from the leverage ratio until March, 31st.
The uncertainty over whether to stick to that expiration date has compounded anxiety in the fixed income markets. Banks have warned that allowing the rule to expire could cause them to opt out of buying government debt and loans, which could trigger another market crisis.
The issue has become a political hot potato, with powerful Democrats pressuring Fed Chairman Jerome Powell to deny Wall Street what they say is an unwarranted break that could increase systemic risk. They point out that the big banks have plenty of cash to buy back stocks and issue dividends.
“This is a victory for lending in communities hit hard by the pandemic and for the stability of our financial system,” said Democratic Senator Sherrod Brown, who previously warned the Fed that extending the exemption would be “serious” mistake”.
Benchmark 10-year Treasury yields jumped about five basis points on the announcement to 1.750%, approaching Thursday’s one-year high of 1.754%.
But Fed officials have said they are confident that expiring the exemption will not hurt Treasury market liquidity or cause disruption because the market has stabilized and the big banks are bursting. of capital.
The leverage ratio was adopted after the 2007-2009 financial crisis as a guarantee to prevent large banks from manipulating other capital rules. It requires them to hold additional capital against assets, regardless of their risk.
But the ratio is quickly becoming the main limit on bank balance sheets, which have swelled following the Fed’s injection of liquidity into the economy amid the pandemic.
Last year, the Fed nearly doubled its balance sheet to over $ 7.7 trillion thanks to about $ 3.4 trillion in bond purchases. This extraordinary intervention, combined with interest rates close to zero, aims to keep money flowing through the banking system.
As a result, bank deposits at the Fed, known as reserves, have skyrocketed to $ 3.9 trillion since the start of the pandemic, according to Fed data on Thursday, and are expected to increase by $ 2 trillion. more dollars before the Fed backs off stimulus efforts.
“This pressure is quite significant,” said Gennadiy Goldberg, interest rate strategist at TD Securities, adding that it could prompt banks to abandon “market support roles”.
Some banks might have to issue preferred stock to add enough short-term capital to handle the increase in deposits, which would dilute common stock from 1% to 2%, Evercore ISI’s Glenn Schorr wrote in a note.
The banks claim that reserves and US Treasuries are indeed risk-free and that it makes little sense to penalize them. (Chart: Bank reserves held at the Fed have skyrocketed,)
The Fed said on Friday that it had taken the complaints into account. Due to continued growth in reserves and Treasury bill issuance, he said he may recalibrate the ratio “to avoid tensions … which could both dampen economic growth and harm financial stability.” “
However, he added that any change to the rule would not erode the overall strength of banks’ capital requirements.
While the Fed’s move appears to be a good compromise to appease both Wall Street and progressive Democrats, overhauling the rules, which will be the subject of public consultation, will likely be a long and busy process, said analysts.
Progressives, who say Powell is inclined to be too friendly with Wall Street on regulatory matters, are generally skeptical of any attempt to break post-crisis rules and may fight the changes. This could leave the market in an uncomfortable limbo, analysts said.
“Unless there is a solution quickly enough, I think there will be a lot of caution in the market and a lot of concerns about volatility,” Goldberg said.
Reporting by David Henry and Michelle Price; additional reports from Noor Zainab Hussain, Karen Brettell, Pete Schroeder and Dan Burns; Editing by Andrea Ricci, Marguerita Choy and Cynthia Osterman