Introduction
Nearly four years ago, the Federal Reserve committed to reconsider the supplementary leverage ratio (SLR) in light of the massive, COVID-driven expansion of the Federal Reserve’s balance sheet. Today, the Federal Reserve’s balance sheet still stands at nearly double its pre-expansion level, but no action has been taken to reform the SLR. Accordingly, there is an urgent need to reconsider the SLR in short order. The current level of the Federal Reserve’s balance sheet, coupled with the existing SLR regulation, results in an unnecessarily binding, risk-blind, capital constraint that is having significant deleterious impacts on financial markets and the economy. In the remainder of this post, we discuss the problems created by risk-blind leverage requirements that have been identified through rigorous academic research.
The Backdrop
The SLR was introduced as a capital requirement for large banks in 2018. The SLR is a risk-blind capital requirement that mandates all large banks to maintain five percent capital against all bank assets irrespective of their risk. Importantly, low-yielding and default-free U.S. Treasury securities and bank reserves issued by the Federal Reserve, the most liquid and risk-free asset in the world economy, must be backed by five percent capital. At the same time, higher-yielding assets such as corporate loans or corporate bonds also require five percent capital under the SLR. In a world in which all assets have the same capital cost, there is a clear and unavoidable incentive to hold higher-yielding assets (corporate loans) than lower-yielding ones (U.S. Treasuries).
Back in 2018, the size of the Federal Reserve’s balance sheet was roughly $4 trillion. Today, the Federal Reserve’s balance sheet stands at $6.8 trillion. The additional $2.8 trillion in Federal Reserve assets are largely financed by issuing bank reserves. In the aggregate, banks must hold all of the bank reserves issued by the Federal Reserve. Accordingly, when the Federal Reserve increases its balance sheet it necessarily increases the amount of risk-free assets held by banks and these assets are subject to the 5 percent capital requirement of the SLR.
Now that the Federal Reserve is so much larger, more banks are adversely impacted by the SLR because they are required to maintain additional capital on all the additional, risk-free, bank reserves. As the amount of capital required by the SLR has risen, the incentives to pull back on low-risk assets such as U.S. Treasury securities have concomitantly increased.
Finally, it is important to fully appreciate how the financial system has changed since 2018. Table 1 below, depicts: 1) the level of the Federal Reserve’s balance sheet, 2) the amount of U.S. Treasury debt outstanding, and 3) the annual interest cost of government debt.
As shown in Table 1, while the Federal Reserve has expanded its balance sheet, we have seen a nearly identical expansion in debt issued by the federal government as both have increased by roughly 65 percent. Moreover, the amount of money the government is spending to service its debt has grown by much more, 83 percent, owing to both an increase in outstanding debt and the general increase in interest rates that has occurred recently.
Indeed, for the first time since records have been kept, the federal government is now spending more on interest payments than on national defense. What’s more, current projections of federal spending suggest that this gap will only widen in the future and that the nation’s interest bill will only become more pressing. As Table 1 makes clear, the financial system in 2025 looks completely different from the one we knew in 2018 when the SLR was introduced.
With this backdrop in mind, it is essential that the U.S. government – including the Federal Reserve – do everything in its power to manage the federal debt, contribute to a well-functioning U.S. Treasury market, and minimize the cost of servicing our national debt. Unfortunately, the current stance of the SLR is antithetical to all these goals.
What Does Research Say About Risk-Blind Leverage Requirements and the U.S. Treasury Market?
We have asserted that leverage requirements are impairing the market for U.S. Treasuries and artificially increasing the cost of government debt. What exactly is the basis for these claims? The best way to assess these claims is to simply look at data-based economic research that has studied the impact of the SLR on U.S. Treasuries and financial markets. Luckily, this is a broad and active area of research. Below, we highlight three relatively recent contributions:
- A 2024 research paper by economists at the Federal Reserve Bank of Boston found that the SLR had significant negative impacts on the ability of large dealer banks to intermediate the U.S. Treasury market. Specifically, they found that in response to a more restrictive SLR, dealers reduced their Treasury holdings, leading to a reduction in trading, an increase in the cost of buying and selling U.S. Treasuries, and a weaker response to Treasury auctions.
- A 2022 research paper by economists at the Federal Reserve Board found that banks respond to balance sheet shocks by reducing their exposure to U.S. Treasuries, particularly through reductions in repo activity. Importantly, the paper distinguishes the SLR’s impact from other regulatory requirements, such as risk-based capital and liquidity coverage ratio requirements, finding that the SLR uniquely constrains a bank’s ability to intermediate the Treasury market.
- A 2023 research paper by economists at the Federal Reserve Bank of New York and others found that when U.S. Treasury dealers face capacity constraints, such as occurs from an increasingly binding SLR, the liquidity of the U.S. Treasury market worsens. In particular, as regulatory constraints become more binding, Treasury markets become more volatile and trading in the U.S. Treasury market becomes more costly.
The research above makes clear that the SLR is imposing well-documented and significant costs on U.S. Treasury markets and the broader economy. Indeed, the U.S. Treasury market underpins essentially every other financial asset in the world. Accordingly, problems in the U.S. Treasury market necessarily migrate broadly throughout the rest of the financial system. In particular, any increase in U.S. Treasury yields or other strains will immediately spill over into the market for home mortgages, auto loans, business loans and essentially any other financial product used by households and businesses. For all these reasons, the Federal Reserve should take immediate action to reconsider risk-blind leverage requirements to address clearly documented problems in the U.S. Treasury market.
Each of the papers above is notable because they are authored by staff of the Federal Reserve system. One might reasonably wonder why so much of this research emanates from within the system. The answer lies in the fact that each of the research papers uses confidential bank data that only the Federal Reserve can access. There is indeed a deep irony that only the Federal Reserve system is truly able to fully assess the implications of leverage constraints on Treasury markets, yet the Federal Reserve has so far failed to act on the findings of its own researchers.
But Wait…There’s More
Much of the research literature and discussion of leverage requirements revolves around the SLR. Lurking in the shadows lies yet another, often hidden, leverage requirement – the Tier 1 leverage requirement. The Tier 1 leverage requirement (T1L) is the precursor to the SLR; it was in effect for decades before the SLR was introduced and is still in effect today. The T1L requirement is essentially the classic, historical leverage ratio that has been used for over 100 years and was arguably a relevant capital metric 100 years ago – capital divided by total assets. The SLR is “supplementary” in the sense that the SLR includes certain off-balance sheet exposures like derivatives and loan commitments that are not recorded in total assets due to technical accounting rules.
One might reasonably ask why the T1L requirement was not “de-commissioned” following the introduction of the SLR. The basic answer simply amounts to the fact that bureaucracies are good at creating new rules and bad at eliminating old, outmoded, and unnecessary rules. Dealing with the SLR without dealing with T1L would be a mistake. Modifying the SLR without dealing with T1L would simply amount to replacing the SLR with T1L as the new risk-blind leverage requirement and we would be back to square one all over again. Accordingly, it is important that T1L be addressed alongside the SLR.
Conclusion
Sample evidence and research, often conducted by Federal Reserve system staff, clearly show that risk-blind leverage requirements have been impairing the market for U.S. Treasuries for some time. The problems in the U.S. Treasury market are all the more pressing due to the steep rise in government interest payments and forecasts for an increase in the amount of government borrowing. The Federal Reserve, and other regulators and policymakers, should act swiftly to address the deleterious consequences of risk-blind leverage requirements on the economy.