Capital buffer reduced by 1.5%, U.S. regulators plan to relax capital rules to promote government bond trading

Amid growing concerns about liquidity in the $29 trillion Treasury market, the three major U.S. banking regulators are preparing to implement a key policy adjustment for the largest banks—reducing the enhanced supplementary leverage ratio (eSLR) by up to 1.5 percentage points.

According to media reports on the 18th, the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) are focusing on adjustments to the enhanced supplementary leverage ratio. This rule applies to the largest U.S. banks, including JPMorgan Chase, Goldman Sachs Group, and Morgan Stanley.

The proposed adjustment would lower the capital requirement for bank holding companies under the eSLR from the current 5% to a range of 3.5% to 4.5%. At the same time, the bank subsidiaries of these institutions may also see their requirements reduced from the current 6% to the same range.

Reports cite informed sources indicating that these revisions are similar to the approach taken by the Trump administration's regulators in 2018, which sought to "tailor" the eSLR calculation method, aiming to adjust it for U.S. global systemically important banks.

However, some experts question the actual effectiveness of this policy and worry that it may exacerbate systemic risks rather than effectively address issues in the Treasury market. The Federal Reserve has announced plans to hold a meeting on June 25 to discuss the proposal, while other regulatory agencies have yet to disclose related agenda arrangements.

Liquidity Crisis Spurs Policy Shift, U.S. Treasury Yields May Drop Significantly

It is noteworthy that the proposal will focus on changing the overall ratio, rather than excluding specific assets like Treasuries, as some observers have predicted.

Powell and other officials have consistently supported the potential revision of the supplementary leverage ratio standards to enhance banks' roles as market intermediaries. In February of this year, Powell expressed his long-standing "concerns about the liquidity levels in the Treasury market" during a House Financial Services Committee meeting.

In April of this year, the impact of Trump's tariff policies shook the market, further intensifying investors' focus on the SLR standards.

The banking industry has long protested that the rule requires large lending institutions to hold capital against their Treasury investments, which undermines their ability to increase holdings of these securities during market volatility, as Treasuries are treated the same as riskier assets. The applicability of the SLR to Treasuries was suspended during the COVID crisis but has since been reinstated.

Estimates from U.S. Treasury Secretary Janet Yellen suggest that adjusting the rule could lower Treasury yields by several dozen basis points.

Michelle Bowman, the Federal Reserve's Vice Chair for Supervision, stated earlier this month that leverage ratios are intended to serve as a "backstop" to risk-based capital requirements. She added:

"When leverage ratios become a binding capital constraint at excessive levels, they can distort the market."

Experts Question: Policy Effectiveness is Doubtful, Systemic Risks May Increase

However, Jeremy Kress, a professor of business law at the University of Michigan and a former Federal Reserve bank policy attorney, expressed skepticism about whether relaxing leverage ratios would encourage banks to purchase more Treasuries.

"When regulators temporarily excluded Treasuries from leverage ratios in 2020, most banks chose not to take advantage of this exclusion because doing so would trigger restrictions on their ability to pay dividends and repurchase stock," Kress said:

"This experience indicates that if banks gain additional balance sheet capacity from changes in leverage ratios, they are more likely to use it for capital distribution to shareholders rather than for intermediary business in the Treasury market."

Graham Steele, a former Federal Reserve member who served as a Treasury official during the Biden administration, stated that there are more targeted solutions to help address the issues in the Treasury market:

"Unfortunately, the deregulation being considered will not improve the situation; it will only make the financial system more fragile."

How this game regarding bank capital rules will ultimately balance market liquidity and financial stability remains to be seen, with the final answer expected at the Federal Reserve meeting on June 25