By David Henry

NEW YORK, (Reuters) – Potentially disruptive disruptions in U.S. Treasuries have rekindled the calls for the Federal Reserve to modify a capital rule that banks claim discourages them supporting the market.

Late October saw a rise in volatility in the bond market, raising fears that it could again seize up like it did during March 2020’s “taper tantrum”, when traders sold Treasuries before the Fed reduced its bond purchases.

The Treasury market is the most liquid and deepest market worldwide and can be a source of great concern. It acts as an indicator for all asset classes and allows the U.S. to function as the reserve currency.

The Supplementary Leverage Ratio, also known as SLR (Supplemental Leverage Ratio), was established after the financial crisis of 2007-09. It is a backup measure to strengthen primary capital rules.

However, COVID-19 and Fed’s large bond-buying programs inundated banks with deposits last Year. Some have now been limited by SLR. This requires that they hold capital against assets without regard to their risk.

The Fed removed deposits that lenders held with the central banking, also known as reserves and U.S. Treasuries, from the ratio for one year to encourage them to continue lending in the troubled Treasury market.

Fed announced that it will launch a formal examination after the exemption expired in March. It has not yet published a proposal for a rule change. This raises concerns from some quarters as central bank board members face major reshuffles.

Bank Policy Institute (which represents major banks) warned in a blog that the Bank Agency should act now to resolve the issues rather than regretting in the aftermath of substantial Treasury market volatility.

It added that tapering and a crisis of debt are possible before any changes in leverage ratios. This increases the risk of Treasury market dysfunction.

JPMorgan Chase (NYSE 🙂 are some of the largest banks that play a critical role in this market. Morgan Stanley (NYSE:) are facing SLR limits, Standard & Poor’s analysts say.

Although tapering will reduce bank reserve pressure, it can continue up until the Fed’s bond-buying program is ended, which isn’t expected before the middle 2022.

Last week, Jerome Powell, Fed Chair, stated at a press conference that the central banking was reviewing SLR as part of its larger Treasury market overhaul. However, Powell did not speak on the proposed rule change.

“It is important to have a liquid Treasury Market…and we must do the things that allow that while still assuring the safety and soundness our biggest financial institutions.”

UNINTENDED CONSEQUENCES

SLR is a supplement to capital requirements that are based on riskiness. Risk-adjusted laws can be bypassed and do not fully protect the system against the complicated products that caused the financial crisis.

Banks disagree and say that the SLR should not require the same capital ratio for virtually risk-free assets like Treasuries or reserves, as it does for loans to businesses.

The SLR could have unintended consequences, such as lowering liquidity in Treasury markets by making it difficult for banks to keep bonds on their books.

Sean Campbell from the Financial Services Forum (representing big banks), said that if it is a binding constraint, it could have perverse consequences like desincerizing activities in low-risk market,” he stated.

However, the market isn’t facing “doomsday scenarios”, he said.

Some analysts believe it may take another market crisis similar to 2020 before the Fed can make an exception again.

As progressive Senate Democrats state that changing the rule would give Wall Street a free pass and increase systemic risk, it is politically hot potato.

Jaret Seiberg from Cowen Washington Research Group stated recently that “we believe the Federal Reserve have not advanced any proposal to fix SLR for political purposes.”

Seiberg suggests that the Fed exempt reserves and increase the SLR requirements enough to make up for the loss. Progressives might be satisfied if the required capital remains the same.

It is likely that this will not happen until Congress confirms a Fed chairperson and vice chairman for supervision. If the Senate does so, the matter could be dragged into 2023.

Seiberg said that big banks would have to face a tightening leverage constraint in the future.