Introduction

This week, the Federal Reserve Board, OCC and FDIC issued a proposal to reform the supplementary leverage ratio (SLR). Reform of the SLR has been anticipated for years – ever since the Federal Reserve committed to propose permanent reform during the COVID pandemic when the deficiencies of the SLR became all too apparent. The proposal and comments from several Fed board members lay out a balanced and rational analysis for the public to examine and comment on. However, there were also a variety of specious claims about the proposal and its effects, which are important to address promptly.

The Proposal Does Not Significantly Reduce Required Capital for U.S. GSIBs

Some have suggested that the Federal Reserve’s proposal will significantly reduce capital for U.S. GSIBs (all of which are Forum members) by more than 20 percent. This claim is both incorrect and at odds with the Federal Reserve’s own analysis.

Capital requirements are applied, first and foremost, at the top-tier holding company level and not at the level of a single subsidiary. This is akin to measuring your financial well-being by considering all of your assets and liabilities. If your 401k retirement savings increases by $100,000 while your house value declines by $10,000 then we should all agree that your total wealth has increased by $90,000 and not fallen by $10,000.

At the top-tier holding company level, the Federal Reserve’s own analysis indicates that the proposal will reduce tier 1 capital by $13 billion or about 1.4 percent. The capital stock at the top-tier holding company is available to absorb any and all losses throughout the entire corporate entity and is the capital level that matters for bank safety and soundness as well as financial stability. To put this into further perspective, the eight GSIBs collectively maintain $1.1 Trillion in tier 1 capital.

Indeed, when the Federal Reserve discusses bank capital levels – either in its Financial Stability Report, or its Supervision and Regulation Report, or in its semi-annual testimony to Congress – it generally cites top-tier holding company capital levels.

Attempts by some commentators to style the Federal Reserve’s proposal as resulting in a large decline in capital are looking narrowly at bank subsidiary capital levels that do not consider the entirety of the financial resources available to the top-tier holding company. Looking at the complete picture, it is clear that the impact on capital levels would be extremely modest.

The Proposal Improves Incentives to Engage in All Low-Risk Activities – Both Under Normal Conditions and Times of Stress

Another claim made about the proposal is that it won’t improve the incentives to intermediate U.S. Treasury markets – either under normal conditions or in times of stress. This statement ignores both the basic logic behind the proposed reform as well as our lived experience with this part of the capital framework.

On the theory side, the logic is clear. A capital rule that charges the same requirement to all assets provides clear disincentives to engage in low-risk assets that provide commensurately lower returns. This is not a complex argument. Anyone who runs a business or makes economic decisions can relate. If the cost of doing a range of different activities does not vary but the benefit is highest for one particular activity which would you choose? The activity with the highest benefit will clearly be chosen among all others. In the case of intermediating the U.S. Treasury market, why should banks engage in that relatively low-risk and low-return business if the capital cost is identical to the cost of making more profitable business loans? Clearly, the effect of a one-size fits all capital requirement like the SLR is to disadvantage relatively low-risk activities such as intermediating the U.S. Treasury market.

On the empirical side, the recent lived experience of the COVID pandemic provides a useful laboratory in which to test the theoretical prediction. During the pandemic, one of the most stressful periods in global history, the Federal Reserve temporarily excluded U.S. Treasuries from the SLR computation thereby reducing the binding nature of the SLR. What happened during this stressful period? Significant research including research conducted by economists at the Federal Reserve and economists at the Federal Reserve Bank of Boston have convincingly shown that during this stressful period large banks engaged more significantly in the U.S. Treasury market which reduced Treasury market volatility and trading costs. Accordingly, both the theory and practice of economics is fully consistent with the prediction that easing the binding nature of risk-blind leverage requirements will improve bank engagement in low-risk activities during both normal times and periods of stress.

Relatedly, some commentators have raised a concern that the recent SLR proposal might simply incentivize large banks to engage in other low-risk activities besides U.S. Treasury market intermediation. It is certainly true that a less binding SLR will improve the incentives for banks to engage in all low-risk activities. We should applaud this development in which markets, rather than government fiat, determine which activities are undertaken by banks for the benefit of the broader economy.

The Proposal is Fully Transparent

Beyond the two arguments above, some have suggested that the Federal Reserve’s SLR proposal is not transparent because it relies on the internationally agreed upon (Basel) GSIB surcharge for each U.S. GSIB (Forum member). In fact, the Basel GSIB surcharge is fully transparent and widely available to the public and has been for years. Each year the Financial Stability Board publishes a list of global GSIBs along with the corresponding Basel GSIB surcharge level. Further, the Office of Financial Research (OFR) maintains a public website that is devoted to tracking Basel GSIB surcharges for all global banks. Finally, the Federal Reserve itself collects and makes public all of the data that is needed to calculate the Basel GSIB surcharges. Accordingly, there is no reasonable sense in which tailoring the SLR to each bank’s Basel GSIB surcharge is anything but fully transparent.

Conclusion

Years ago, the Federal Reserve committed itself to reconsider the SLR in light of its increasingly binding nature that was brought on by long-lived and active policy choices of the Federal Reserve and the U.S. government during the pandemic. The Federal Reserve and other agencies have now made good on this promise. The proposal represents an important first-step in improving the large bank capital regime. The proposal does not, however, significantly reduce large bank capital, frustrate incentives to intermediate the U.S. Treasury market, or reduce the transparency of large bank capital regulation. Any such claims are both misleading and demonstrably false.