How much impact does the U.S. modification of SLR have on U.S. Treasury bonds?

Debt is temporary, but credit is eternal. U.S. Treasuries are now like being "on the edge of a cliff." How to handle the massive $36 trillion U.S. debt and the high interest it brings is undoubtedly the biggest challenge for Treasury Secretary Janet Yellen. She has indeed proposed many new and old solutions to alleviate fiscal pressure.

In our previous report ("The Crux of U.S. Debt: How to 'Strongly Buy' Under 'Strong Sell'?"), we emphasized that the current Trump administration does not have a clear demand for "debt reduction." According to the latest estimates from the Congressional Budget Office (CBO), the "freshly minted" tax and spending bill from the House will add an additional $2.4 trillion to the deficit in the future (this is just a static estimate and does not include interest from the deficit). The pressure on U.S. debt has reached the demand side, so who will take over?

In our previous report (same report), we categorized the traditional demand for U.S. debt into four main types: the Federal Reserve, U.S. commercial banks, foreign investors, and U.S. residents (including households and businesses, excluding residents holding through commercial banks indirectly). Among them, the Federal Reserve's increase in holdings requires a significant shift in monetary policy, which is difficult in the short term; foreign investors are constrained by the current foreign trade and geopolitical landscape, as well as concerns about the sustainability of U.S. debt, and their demand is not as "firm" as before. For the U.S. government, there are essentially two paths: one is to "make a temple out of a snail shell," digging deep into existing demand; the other is to "forge a new path," seeking new sources of fiscal revenue growth. Interestingly, it seems that both paths have been found by Yellen as "lifelines": releasing the demand of commercial banks through regulatory relaxation and tightly embracing the currently popular "stablecoins." In this report, we will first discuss the space for commercial banks.

Regulatory relaxation mainly focuses on the bank's Supplementary Leverage Ratio (SLR). SLR is a key indicator in U.S. bank regulation, calculated as Tier 1 capital divided by total leverage exposure (including assets and off-balance-sheet items such as derivatives), as required by Basel III. The current requirements are:

All large banks (Category I-III, roughly speaking, those with assets exceeding $250 billion) must maintain an SLR of 3%;

Among them, globally systemically important banks (GSIBs, of which there are 8 in the U.S.) must additionally maintain an enhanced SLR (eSLR) of 2% (5% total).

Why does SLR affect the U.S. debt market? The most critical point is that when calculating total leverage exposure, all assets of commercial banks are treated "equally," without risk adjustment, which is in stark contrast to risk-weighted indicators such as capital adequacy ratios, where the credit risk weight of U.S. Treasuries is often 0. In addition to allocating U.S. Treasuries on the asset side, banks (or their subsidiaries) are also major market makers for U.S. Treasuries, and the trading positions of U.S. Treasuries are similarly constrained by leverage ratios, which directly affects the liquidity of the U.S. debt market.

Previously, during the pandemic in 2020, U.S. regulators temporarily allowed U.S. Treasuries and bank deposits at the Federal Reserve to be excluded from SLR calculations to alleviate the pressure on U.S. Treasury liquidity and the surge in deposits The U.S. is likely to revise the SLR rules this summer. On one hand, the current volatility in the U.S. Treasury market and liquidity pressures are indeed present; on the other hand, numerous regulatory agencies, including the Treasury and the Federal Reserve, have successively proposed demands and suggestions for revising the SLR, which aligns with the deregulatory policy stance of Trump 2.0.

How to revise? We believe there are mainly two directions: one is to modify the calculation method or scope of the SLR, such as the current high demand to exclude U.S. Treasuries from the SLR calculation. The second is to lower the standards, for example, reducing the standard for GSIBs to 3% or lowering it overall.

However, excluding all U.S. Treasuries from the SLR calculation carries risks. Especially considering the "cautionary tale" of Silicon Valley Bank in 2023, and the current large-scale paper losses that U.S. banks still hold in bonds (reaching $431.2 billion in Q1 2025). Before April this year, Nellie Liang, the Deputy Secretary of the Treasury responsible for domestic finance, proposed an extremely conservative reform plan—making the eSLR counter-cyclical and exempting banks' deposits at the Federal Reserve from the supplementary leverage ratio calculation.

How will it affect? To what extent?

We tend to believe that the main purpose of the U.S. relaxing the SLR is to improve liquidity in the U.S. Treasury market, and expectations for U.S. banks to increase their holdings are not very high. Considering the risks comprehensively, we believe the priority for U.S. regulators is to exempt relevant banks from the SLR calculation for U.S. Treasuries held for trading.

Exempting U.S. Treasuries is primarily aimed at alleviating the pressure on banks' market-making. One of the most significant characteristics of the U.S. Treasury market after the pandemic is the overall deterioration of liquidity conditions, making it prone to large fluctuations. There are many reasons behind this, one important point being that primary dealers, who are significant liquidity providers in the U.S. Treasury market, are accumulating more and more U.S. Treasuries: on one hand, the supply of U.S. Treasuries has increased, and on the other hand, the demand from other entities for U.S. Treasuries has declined, such as the Federal Reserve's balance sheet reduction and waning interest from overseas investors.

This portion of U.S. Treasuries (held for trading) will directly affect banks' leverage ratio indicators. Among the 25 primary dealers in the U.S., 21 belong to large bank holding groups (according to bank regulation), and these U.S. Treasuries continuously increase regulatory pressure on banks. According to a SIFMA study on eight systemically important banks in the U.S., each additional $1 billion in U.S. Treasuries will lead to a decrease of 4.87 basis points in the SLR indicator. As of December 2024, the eight banks held over $640 billion in U.S. Treasuries for trading, and if exempted, could average an increase of 3.94 percentage points in the SLR. From the indicators in the first quarter of this year, the SLR of these eight banks is just a step away from the 5% red line (see Figure 7), especially for banks with large trading operations, such as Goldman Sachs and Morgan Stanley.

The impact of modifying the SLR on banks increasing their holdings of U.S. Treasuries may be "marginal." To calculate the upper limit, we still take the case of complete exemption as an example. However, direct calculations are not easy, because theoretically, as long as the asset scale allows, U.S. banks' capacity to increase their holdings of government bonds would be quite considerable (after all, the current asset scale of U.S. commercial banks exceeds $24 trillion), This is clearly unreasonable.

In fact, American commercial banks are generally quite conservative. From the perspective of asset composition, corporate/residential loans and mortgages/securities are the main components, with a very limited scale of U.S. Treasury holdings. As of April this year, American commercial banks held approximately $1.8 trillion (including government agency bonds) in U.S. Treasuries, accounting for about 7.6% of total assets, which is close to the highest level recorded. Moreover, the holdings of U.S. Treasuries are also very concentrated, with the largest 25 commercial banks in the U.S. holding $1.46 trillion, accounting for 79% of all commercial banks' holdings of U.S. Treasuries.

We believe that the SLR exemption can at most absorb one-tenth of the future new deficit. The increase in U.S. Treasury holdings by American commercial banks mainly comes from two aspects: first, the objective allocation demand brought about by the expansion of their own asset scale; second, the rising willingness to hold U.S. Treasuries, reflected in the increasing proportion of U.S. Treasuries in their assets. The impact of the SLR exemption mainly comes from the latter. Historically, before the outbreak of the pandemic in 2020, the central tendency of U.S. commercial banks' holdings of U.S. Treasuries was around 4.2%, remaining basically stable.

However, after the pandemic, this central tendency systematically increased. From April 2020 to March 2021, the Federal Reserve briefly excluded U.S. Treasuries from the SLR calculation, which we estimate caused the proportion of Treasuries held by banks to rise by about 0.8 percentage points within a year (excluding the impact of the Federal Reserve's easing). Referring to this value and considering the expansion of bank asset scales, this impact will at most increase by $200 billion to $300 billion per year (this is still a relatively extreme scenario). According to previous estimates by the Congressional Budget Office, without considering tax cuts, the average annual fiscal deficit over the next decade is around $2.1 trillion. Using the term "a drop in the bucket" to describe the role of SLR in debt reduction may be more appropriate.

Author of this article: Tao Chuan, Shao Xiang, Lin Yan, Source: Minsheng Securities Macro Research, Original Title: "Is the Bessent 'Debt Transformation' Strategy Reliable? (Part One): The 'Origin and Development' of SLR"

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