US banks: leverage ratios under pressure

The US economy is facing its most serious crisis for 70 years. Initial estimates suggest that GDP could have contracted by 15% (quarter-on-quarter) in the second quarter of 2020, following a 1.3% contraction in the first quarter. In order to mitigate the economic consequences of the Covid-19 pandemic, the Treasury and the Federal Reserve (Fed) have made some major fiscal, monetary and regulatory decisions since mid-March. These have included exceptional measures to bolster the liquidity of companies and markets. These measures have led to a sharp worsening of bank debt leverages¹.

Indeed, bank balance sheets have expanded considerably since mid-March (Chart 1). Drawing against confirmed credit lines (recorded as off-balance sheet items before they are paid out) and issuance of guaranteed loans under the Paycheck Protection Program (PPP)² have both increased balance sheet assets. Whether they have acted as intermediaries, direct counterparties or correspondent banks, US banks have also seen their central bank reserves increase substantially

following the monetary policy measures taken by the Fed (securities purchasing, emergency loans, specific refinancing schemes, liquidity swaps with foreign central banks). Lastly, the fresh expansion in inventories of Treasuries by specialised primary dealer subsidiaries has also resulted in the expansion of consolidated balance sheets. Although loans guaranteed by the federal government (PPP loans), like reserves at the Fed and US Treasuries, have a zero risk weighting (for the risk-weighted capital ratios), they are included in the calculation of leverage exposure (as the denominator of the leverage ratio³).

Concerned that leverage requirements would hamper banks’ capacity for credit intermediation and their activity in the Treasuries market, regulators have temporarily relaxed the rules. For one year, banks’ reserves at the Federal Reserve and Treasury securities, whether used as collateral or not, may be deducted from the leverage ratios of large holding companies and depository institutions. With little prospect of the Fed reducing markedly its balance sheet (and therefore automatically central bank reserves) in the short term, regulators could be forced to extend the exclusion of reserves from leverage exposure for a lengthy period.

Relaxation of balance sheet constraints

Leverage constraints in the USA

In the USA, several leverage ratios exist side by side.

All banking organisations are subject to a simple leverage ratio which compares Tier 1 capital to average balance sheet assets. The minimum level is set at 4%.

Smaller depository institutions (those with consolidated assets of less than USD10 billion, community banks), that seek exemption from any capital adequacy measure based on risk-weighted assets, have a tougher minimum level⁴ of 9% (Community Bank Leverage Ratio or CBLR)⁵.

Only the biggest banks (those with total assets of more than USD250 billion or at least USD75 billion in non-bank assets, weighted short-term wholesale funding or off-balance sheet exposure)⁶ are subject to the Basel supplementary leverage ratio (SLR) requirement. This compares Tier 1 capital to total exposure, which includes all assets recognised on the balance sheet⁷ in accordance with applicable

accounting rules (excluding derivative exposures and securities financing transaction exposures which are treated separately), and a reduced measure of off-balance sheet commitments⁸. Derivative exposures and securities financing transaction (SFT) exposures are measured on the basis of gross values; netting of certain lines is allowed only under restricted conditions (see Box). The minimum level for the SLR is set at 3%.

The SLR requirement for banks predominantly engaged in custody, safekeeping and asset servicing activities (such as Bank of New York Mellon, State Street and Northern Trust) was relaxed in November 2019⁹. The new rule¹⁰, in force since 1 April 2020, excludes from the definition of their leverage exposure (the denominator of the Basel leverage ratio) a proportion of excess reserves held with the central bank¹¹ (equivalent to the amount of deposit liabilities that are linked to fiduciary or custody and safekeeping accounts). This exclusion covers not only deposits at the Fed, but also those with central banks in other OECD countries.

The eight global systemically important banks (G-SIBs) are subject to an enhanced requirement on consolidated figures (enhanced Supplementary Leverage Ratio, or eSLR, set at 5%) and for their depository institution subsidiaries (eSLR of 6%)¹².

The relaxations introduced since March

Regulators have not relaxed the basic leverage ratio. The Dodd Frank Act (Collins amendment, section 171) limited their scope to do so by requiring that any minimum weighted capital or leverage requirement is no lower than “generally applicable requirements” in force at the time the law was passed. In summary, the July 2010 act created a permanent floor for any new capital adequacy rule. In the absence of a vote in Congress, the leverage ratio cannot be reduced below that in force in 2010 (set at 4% for the ratio of Tier One capital to average balance sheet assets).

The three banking regulators (Fed, FDIC and OCC) have, however, been able to neutralise the impact of participation on two specific schemes introduced in response to the pandemic: the Money Market Mutual Fund Liquidity Facility (MMLF)¹³ and the Paycheck Protection Program Lending Facility (PPPLF)¹⁴. Under interim rules, published on 19 March¹⁵ and 9 April¹⁶ respectively, assets used as collateral for the MMLF and the PPP loans used as collateral for the PPPLF can be excluded from the calculation of all leverage ratios applied in the USA, namely average consolidated assets for the calculation of the basic leverage ratio and the CBLR and the total leverage exposure used in the calculation of the SLR figure¹⁷.

On 6 April, the three banking regulators (Fed, FDIC, OCC) relaxed the specific leverage constraint for community banks, in accordance with section 4012 of the Cares Act, introduced on 27 March¹⁸. The minimum level for CBLR was reduced to 8% from the second quarter of 2020.

A grace period of two quarters was accorded to community banks whose leverage ratio falls below 8% but remains at 7% or above. This relaxation will remain in force until 31 December 2020, or the end of the state of emergency if this comes sooner. The minimum will be increased to 8.5% on 1 January 2021 and then 9% in 2022, taking it back to its level at 1 January 2020.

The Basel SLR requirement has been relaxed under two interim rules. First, in April, the Fed announced a provisional modification for the calculation method for the SLR for bank holding companies, saving and loan holding companies and US intermediate holding companies of foreign banking organisations¹⁹. The new calculation method will apply from 1 April 2020 to 31 March 2021, and excludes Treasuries and reserves at the Fed from the denominator of the ratio²⁰. Then in May, the FDIC and OCC joined forces with the Fed to extend the new SLR calculation method to all depository institutions with balance sheets of more than USD250 billion (subject to Category II and III capital standards) or subsidiaries of US G-SIBs²¹.

Little room for manoeuvre

A deterioration of leverage ratios

The SLRs of certain large banking groups dropped in the first quarter of 2020 on a consolidated basis and/or at some of their main depository institution subsidiaries (Charts 2 and 3).

However, the reported fall understates the deterioration of debt leverages. This is because the denominator of the SLR is calculated as the average of positions booked during the quarter: total exposure is the sum of the daily average of balance sheet exposure and the average of the three month-end amounts of off-balance sheet exposure. As the Covid-19 crisis only began to have significant effects on bank balance sheets from March, the increase in leverage ratios is not fully reflected in the first quarter figures.

The new definition of total exposure has given SLRs a significant boost

There is no doubt that the exclusion of reserves at the Fed and Treasuries from the definition of total exposure frees up a not insignificant quantity of capital²² (Tables 1 and 2).

The aggregate amount of deposits at the Fed for all depository institutions has already exceeded its previous record, set following QE3 in October 2014 (USD2,820 billion). From USD1,550 billion at the beginning of the year, reserves at the Fed had risen to USD2,350 billion by the end of the first quarter before surging to USD3,260 billion on 3 june (Chart 4). Nor has the upward trend in reserves yet run its course. All things being equal, continued expansion of the Fed’s balance sheet through asset purchases (QE) and the Treasury’s plan to reduce its holdings at the Fed (to USD800 billion, from USD1,430 billion at 3 June) will increase the bank reserves held with the Fed by at least USD1,000 billion by the end of September²³. Granted, the maturing of the Fed’s liquidity swaps will automatically destroy some of the reserves created²⁴, but the possible increase in the scale of measures to support lending to small and medium-sized businesses could support their expansion.

In general terms, the exclusion of Treasuries has improved SLRs for depository institutions whose portfolios of Treasuries have expanded in recent years, and for holding companies whose subsidiaries include the main US primary dealers (Chart 5). The relaxation of the constraint will also allow primary dealers to ‘absorb’ the massive issuance of Treasuries planned for the second and third quarters of 2020 to help finance the economic support package (nearly USD3,700 billion in net issuance).

But there is little room for manoeuvre

For various reasons there are still strong constraints on the balance sheets of US banks: 1) the rule has only been relaxed on a temporary basis (to 31 March 2021); 2) some banks could be discouraged from using the relaxed calculation method as doing so would mean that dividend payments would be subject to approval from their supervisor; 3) the rule explicitly neutralises the effect of this exclusion for the calculation of the G-SIB surcharge (in other words, the assessment of the systemic importance of a bank remains based on total exposure, including reserves at the Fed and Treasuries). Given the near-immutable nature²⁵ of the reserves created, unless the Fed markedly reduces the size of its balance sheet (which looks unlikely in the short term) regulators could be forced into a lengthy extension of the change in the calculation of the leverage ratio.

In addition, over the next few months, risk-weighted capital requirements are likely to become more crucial in assessing capital requirements due to an increase in credit risk and the introduction of the Stress Capital Buffer²⁶.

With repo, or without?

The terms of the second interim rule (issued on 15 May) raised questions about the treatment of Securities Financing Transactions (SFT: securities borrowing or lending transaction, repurchase agreements or reverse repurchase agreements; see Box). It is true that SFTs represent a non-negligible share of leverage exposure of certain major US banks (Chart 6). Their exclusions would also allow primary dealers to absorb more easily the abundant issuance expected from the Treasury: their balance sheets are growing not only because of the expansion of their inventories of securities, but also because of repo loans taken out to finance the former²⁷. However, regulators have not formally excluded SFTs in either of the two interim rules²⁸. The second rule merely stipulates that the total value of on-balance sheet Treasuries may be excluded from the leverage calculation whether or not they are used as collateral for financing and even where the transaction increased leverage²⁹.

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The current context provides further evidence, if it were needed, of the close links between the monetary and regulatory frameworks. Last September, the scarcity of reserves at the central bank, with regard to the liquidity requirements then in force, significantly perturbed the repo markets and forced the Fed to re-expand its balance sheet. Today, the abundance of reserves created by the various monetary support packages is forcing regulators to relax their leverage standards.The details of the relaxation of the Basel leverage constraints should not present any threat in terms of financial stability (only ‘safe’ assets are excluded from ‘leverage exposure’). The temporary nature of the new arrangements, the retention of the calculation of the surcharge for systemically important banks and the possible increase in risk-weighted capital requirements³⁰ would appear to reduce the possibility that banks will increase their exposure to risky assets.

Over the next few months, risk-weighted capital requirements are moreover likely to be more crucial in assessing banks’ capital requirements due to an increase in credit risk (economic crisis, the new Current Expected Credit Losses accounting rules on provisions) and the application of the Stress Capital Buffer³¹.

¹ For a banking organisation, debt leverage corresponds to the ratio of the book value of assets and the book value of shareholders’ equity.

² A programme of loans to small businesses guaranteed by the federal government via the Small Business Administration. Only the share of PPP loans used as collateral under the Fed’s Paycheck Protection Program Lending Facility (PPPLF) is excluded from leverage calculations.

³ Such rules seek to guarantee that the total exposures and commitments of a bank, irrespective of the associated level of risk, do not exceed a certain multiple of its capital. The leverage ratio is defined as the inverse of debt leverage, that is to say as the ratio of equity to total exposure.

⁴ In accordance with the recommendations of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), passed into law by President Trump in May 2018 (section 201 of EGRRCPA).

⁵ Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Capital simplification for Qualifying Community Banking Organizations, September 2019.

⁶ The final rules, Changes to applicability thresholds for regulatory capital and liquidity requirements and Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations of 10 October 2019, modified the application thresholds for enhanced capital and liquidity requirements.

⁷ Items excluded from Tier 1 capital in the numerator of the ratio (e.g. holdings in entities excluded from the calculation of regulatory capital) must also be deducted from the balance sheet exposures in the denominator.

⁸ The measurement of off-balance sheet exposures using the credit exposure equivalent conversion factors of the standardised Basel approach, adding a floor of 10%. A uniform 10% conversion factor is used for exposures that are unconditionally cancellable.

⁹ In accordance with Section 402 of the EGRRCPA.

¹⁰ Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2019), Regulatory Capital Rule: Revisions to the Supplementary Leverage Ratio to exclude certain central bank deposits of banking organizations predominantly engaged in custody, safekeeping, and asset servicing activities, Final rule, November 2019.

¹¹ Figures for reserves held in excess of required reserves no longer have meaning as the Fed removed its minimum reserve requirement as part of its updated monetary policy of 15 March (reduction in required reserve coefficient effective from 26 March).

¹² Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2014), Regulatory Capital, Revisions to the Supplementary Leverage Ratio, Final rule, September 2014

¹³ Under this scheme, the Federal Reserve of Boston makes secured loans to banks. The eligible collateral consists of assets purchased from money market funds (US Treasuries, MBS and debt securities issued by the Agencies, ABCP and unsecured commercial papers issued by investment-grade US counterparties, and US municipal short-term debt). The scheme is due to last until 30 September 2020.

¹⁴ The PPPLF programme allows banks to obtain liquidity against loans made to small businesses under the Paycheck Protection Program introduced by the Cares Act. The principal amount and maturity of the secured loans made by the Fed to eligible borrowers match those of the PPP loans pledged as collateral (whether these were originated by the borrower itself or purchased from other institutions). The scheme has no upper limit and is due to last until 30 September 2020.

¹⁵ Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2020), Regulatory Capital Rule: Money Market Mutual Fund Liquidity Facility, Interim final rule, March 2020.

¹⁶ Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2020), Regulatory Capital Rule: Paycheck Protection Program Lending Facility and Paycheck Protection Program Loans, Interim final rule, April 2020.

¹⁷ Assets pledged as collateral to the MMLF and the PPPLF can also be excluded from the risk-weighted assets calculated under advanced approaches and standardised approach.

¹⁸ Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2020), Regulatory Capital Rule: Temporary Changes to the Community Bank Leverage Ratio Framework, Interim final rule, April 2020.

¹⁹ Federal Reserve System (2020), Regulatory Capital Rule: Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio, Interim final rule, April 2020.

²⁰ This will also apply for the calculation of total loss-absorbing capacity (TLAC) and the long-term debt (LTD) requirement.

²¹ Department of Treasury, Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation (2020), Regulatory Capital Rule: Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio for Depository Institutions, Interim final rule, May 2020.

²² Only for those holding companies and depository institutions for which the leverage requirement is the most restrictive of the solvency requirements

²³ Assuming that the growth in the Fed’s balance sheet will be limited to public sector asset purchases and that these will stabilise at USD100 billion per month

²⁴ These lines are not likely to be renewed given the relaxation of financial conditions on the repo, commercial paper and FX swap markets.

²⁵ Save for changes in autonomous factors

²⁶ This rule, introduced by the Federal Reserve in April 2020, aims to simplify the regulatory framework by reducing the number of capital requirements that need to be satisfied. To achieve this, a Stress Capital Buffer has been introduced, the size of which, for each bank, will be fixed each year following CCAR stress tests.

²⁷ Under a repo transaction, the borrower’s liabilities increase by the amount borrowed under the repo, and its assets by the cash received. The security used as collateral remains on the balance sheet of the borrower (which retains its economic ownership).

²⁸ When they issued the first rule, regulators explicitly raised the question of the opportunity to exclude SFTs from the calculation of leverage exposure, whilst in the second rule they raised the question of the specific type of SFT to be excluded.

²⁹ The 15 May rule specifies that the exclusion of Treasuries also applies to securities “borrowed” (received) by the lending bank in a security-for-security repo-style transaction, even when they have been re-pledged as collateral in a SFT.

³⁰ The introduction of the Stress Capital Buffer could result in a tightening of solvency requirements for the G-SIBs according to the Fed.

³¹ See Note 26.