Swiss Miss: The Fed, Basel III, and SLR

On Wednesday, March 31, 2021, the one-year waiver of the applicability of the Supplementary Leverage Ratio (“SLR”) to banks, which was granted by the Board of Governors of the Federal Reserve System (the “Fed”) on April 1, 2020, expires and, despite vigorous pleas from America’s biggest commercial banks, the Fed announced on Friday, March 19, 2021, that the waiver would not be extended. The SLR requires that banks hold reserves calculated based on their respective asset holdings. The Fed waiver suspended the reserve requirement with respect to holdings of U.S. Treasuries and cash. This was intended to make it easier (i.e., less expensive) for banks to hold Treasuries and cash in the face of the injection of liquidity by the Fed, Congress, and the related sale of Treasuries to fund the resulting debt.

While the results of the re-application of the SLR will not be fully known until after March 31, it is clear that the capital requirements for the largest U.S. banks will increase and/or the banks’ holdings will change. All this is occurring in the context of the extraordinary liquidity brought on by the combined efforts of the Fed and the series of COVID relief bills passed by Congress, most recently the $1.9 TRILLION American Rescue Plan Act signed by President Biden on March 11, 2021.

The Fed, Basel III, and SLR

The SLR is a creation of the Basel III Accords. It was proposed in 2010 and finalized in January 2014. The SLR imposes a requirement that banks and bank holding companies hold increased capital buffers with respect to assets they hold. It is intended to help prevent failures of banks and affiliated financial institutions in case of calamitous downturns akin to the Great Recession of 2007-2009. It is perhaps useful to consider for a moment that the balance sheets of banks are in a sense “upside down.”

For a bank, deposits are liabilities – when asked, or at times specified, the bank must give the deposit money back to the depositor or his, her, or its assignee. In contrast, loans are assets, where the bank is entitled to get back money lent, either at maturity or on default. The SLR is computed taking into account a bank’s assets (including derivatives) in case they cannot be liquidated efficiently, to create a buffer if there should be a “run” on deposits, etc., as occurred in 2008.

U.S. Banks

The SLR for an institution is calculated by dividing its Tier One Capital (basically the common stock PLUS, subject to certain limitations, certain preferred stock, and similar securities) by the sum of balance sheet assets and certain off-balance sheet assets (including exposure to derivatives). Importantly, the calculation ignores the relative riskiness of any one asset compared to another. The calculation of derivative exposure is particularly complex, as it begins with the replacement cost of the derivative PLUS the potential future exposure, a computation that uses what is known as the “Current Exposure Method” or CEM, which in turn is driven by the notional expected future value of the asset only partially netted against the estimated discounted future value of the derivative.

U.S. banks since 2018 must have a 3% buffer as part of meeting their SLR. Globally Systemic Important Banks (“G-SIB,” the largest international banks as, e.g., JP Morgan Chase, Citigroup, etc.) in the U.S. must have at least an additional 2% of buffer, or an aggregate of 5%, to meet the Basel III requirements. If an institution falls below the required buffer level, it may not make capital distributions (dividends and/or buy-backs) and may not pay discretionary bonuses to management.

Swiss Miss

The Bank for International Settlements (“BIS”) was organized on May 17, 1930, in the wake of the October 1929 onset of the Great Depression to facilitate the clearing of international transactions. It was and continues to be in Basel, Switzerland. Its members are the central banks of several nations. As a result of the Great Recession, the Basel Committee on Banking Supervision of the BIS convened a series of meetings; first of the central banks of the Group of 10, and since 2009 all of the G-20.

Those meetings led to a series of recommendations to improve the stability of and to reduce the risk of failure of, banking institutions. Those recommendations are known as the Basel Accords, specifically Basel I, Basel II, and Basel III. SLR is, as noted above, a product of Basel III. Basel III is not binding on banks; otherwise, the Fed’s April 1, 2020, waiver would have required an international meeting, negotiations, and perhaps an accommodation. Nonetheless, most of the time the Fed, as America’s central bank, will follow the recommendations of the Basel Accords, including the SLR.

SLR One-Year Waiver

So what then is the consequence of the end of the one-year waiver? As of April 1, 2021, a bank must hold an SLR buffer computed based upon (among other things) the amount of cash on deposit and U.S. Treasuries held, even given the historically low yields on Treasuries. Again, as noted above, the financial system is “awash” with cash, and banks are hoping (according to the financial press) to avoid imposing negative rates (i.e., “storage charges”) on depositors.

Nonetheless, bank earnings would be reduced due to a “regulatory requirement,” and not to any operational shortfall. One RATIONAL (in terms of what is in the best interest of the bank and its shareholders) decision would be to sell Treasuries held and to replace them with higher-yielding bonds, notes, etc. Such selling would occur in the face of ever-increasing Treasury auctions as the country seeks to finance the enormous debt created by the five stimulus acts passed to deal with the COVID-19 pandemic. Such sales, if they occur, would almost certainly result in the U.S. Treasury having to pay higher interest rates on Treasury securities to make them attractive to investors. One cannot know for certain, but it appears that the insistence on stability sought by the requirements of Basel III may instead result in a Maginot line whose uncertain “protections” the trillion-dollar Treasury market may come to detest.

If you have any questions about this post or any other related securities or general business law matters, please feel free to contact me at pdhutcheon@norris-law.com.