Say what?

Let’s lower US bank capital to reduce Treasury market fragility while Fed QT continues?

While June FOMC is next week, I think the Fed waits for more data to judge the impact of tariffs, tax legislation and economic policy uncertainty on the economy until September. So, this post instead focuses readers on two related paradoxes:

1) Future proposed changes to reduce US bank capital requirements to allow banks to “hold more Treasuries” even as stagflation and recession probabilities are elevated; and

2) Continued Federal Reserve quantitative tightening (QT) amidst handwringing about “Treasury market fragility” so lowering bank capital is a “must do” item.

Changes to US bank regulatory capital standards to “reduce Treasury market fragility” while 1) Fed balance sheet shrinkage is ongoing, 2) the government budget deficit is expanding and the 3) US current account deficit is narrowing are unlikely to prove effective. Instead, lower levels of US bank capital and concerns about the efficacy of US regulation and supervision in the context of rising US macroeconomic risks may erode US banks’ preeminent position among global investors in banks.

A range of less than Capitol ideas about US bank capital

- Since the pandemic, US officials of both political parties have been attracted to proposals to remove Treasuries from large US banks’ supplementary leverage ratios (SLRs) even as both parties continue to run ever larger government budget deficits relative to GDP. [1] These calls to reduce non-risk based bank capital appear rooted in the idea of addressing “Treasury market fragilities” through financial regulation as opposed to more sound fiscal policy.

- Some in the US banking lobby are also advocating for changes to the risk-based capital surcharge for the most systemic US banks, or G-SIB surcharge, stating that it also is acting as a “unnecessary brake” on US banks’ intermediation of Treasuries.

- Finally, there also is advocacy from some on the Hill that the Tier 1 leverage ratio, which is a non-risk-based regulatory capital requirement that impacts all US banks, be reexamined, claiming that it constrains US bank investments in Treasury securities.

- In June the FDIC submitted a public notice that it had filed a proposed modification to SLR requirements to the White House Office of Management and Budget for review, suggesting that a proposed revision on the SLR is coming.

Since the November 2024 election (dotted red line), a number of hedge funds have traded the swap-cash basis trade on the notion that prospective changes in US bank leverage ratios imply that banks will buy more Treasuries and the spread between SOFR swaps and comparable maturity Treasuries would rise. The partial liquidation of this popular trade was a factor in April “liberation day” (solid red line) Treasury market volatility.

Stagflationary and even recession storm clouds on the horizon is the wrong time to discard the umbrella that more capital provides US banks. Banks are levered plays on the real economy and require more capital, not less, when the macro outlook is highly uncertain.

Financial regulation needs to be consistent in promoting sound risk management. Eliminating bank capital requirements for Treasuries when they exhibit heightened price volatility and when Treasuries may enter a long-term bear steepening due to structural factors (no more Cold War peace dividend, deglobalization, aging demographics, reduced immigration) is inconsistent with sound bank risk management. The Bloomberg chart below from highlights market perceptions of rising US sovereign risks.

And yet the eSLR isn’t binding on most US G-SIBs…