Calls to Exclude U.S. Treasuries from Leverage Ratios, signal a Banking Sector Warning
A recent letter (see full letter here) from the International Swaps and Derivatives Association, Inc. (“ISDA”) to the Board of Governors of the Federal Reserve System (the “Federal Reserve”) highlights a larger risk in the US and international banking sector than what is commonly perceived by the market.
The letter, dated from 5th of march 2024, emphasizes the urgent need for reform in the supplementary leverage ratio (SLR) and enhanced supplementary leverage ratio (eSLR) framework. Specifically, it calls for the exclusion of on-balance sheet U.S. Treasuries from the total leverage exposure used in calculating the SLR for global systemically important bank holding companies (GSIB surcharge). This reform is seen as crucial to preserve the resilience of the U.S. Treasury markets, the U.S. economy, and the international financial system at large.
Though this issue may not be in the forefront of public attention, the arguments put forth in the letter are indeed alarming. Banks are advocating for U.S. Treasuries to be excluded from their SLR calculation for several key reasons.
Firstly, U.S. Treasuries are traditionally regarded as the “risk-free asset” due to being backed by the full faith and credit of the U.S. government. Excluding them from leverage ratio calculations implies that banks perceive them as risky, which could potentially undermine confidence in U.S. government debt.
Secondly, the SLR serves as a critical backstop to risk-based capital requirements, ensuring that banks do not become over-leveraged even with assets considered to be safe. The proposal to carve out Treasuries from this calculation weakens the protection against excessive leverage.
Furthermore, if Treasuries are excluded, banks might be inclined to accumulate significant amounts of Treasury debt without it impacting their SLR. This concentration of risk heightens the interconnectedness between the banking system and government debt, posing systemic risks.
The request for this exclusion also hints at banks’ concerns regarding the size of their Treasury holdings compared to their capital base. This could potentially signal broader anxieties about the U.S. fiscal situation and government debt levels.
Any perception that banks require special exemptions for holding U.S. government debt could shake global confidence in Treasuries as a safe haven asset and could impact the status of the U.S. dollar.
While this request is framed as a technical regulatory matter, its implications are concerning in terms of how banks perceive U.S. Treasuries and the potential systemic risks it could pose. It warrants close monitoring by regulators and policymakers.
Adding to this backdrop is the recent announcement of the end of the Bank Term Funding Program (BTFP), which was created following last year’s banking failures, notably at Silicon Valley Bank, that is suppose to end 11 March 2024. The BTFP provided loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions, with U.S. Treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral.
With the conclusion of the BTFP, are banks signalling a potential banking crisis on the horizon? Or perhaps, even more significantly, are they indicating concerns about an impending international financial crisis, given the central role that U.S. Treasuries play in the global financial markets?
These questions underscore the gravity of the situation and the need for careful observation and action by financial authorities. Or will authorities once again be caught unaware, as they were during the 2008 global financial crisis?
Stay nimble!
Author: Antonio Fernandes. Disclaimer: The opinions and views here expressed reflect only the author’s views.
