This Bank Regulation Is Undermining the Recovery

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The Federal Reserve is deploying vast resources to ensure that the U.S. economy recovers as fully as possible from the coronavirus pandemic. It and other regulators shouldn’t let a flaw in banking rules get in the way.

At issue is the leverage ratio, a rule that requires the largest U.S. banks to have at least $5 in equity capital for each $100 in assets. Unlike other capital requirements, which consider the riskiness of assets, the leverage ratio rule doesn’t differentiate: Everything counts toward the total, from subprime loans to the cash reserves that banks hold at the Fed. It’s meant to act as a backstop, guaranteeing that capital doesn’t fall below 5% of assets no matter what the risk-sensitive measures permit.

Lately, though, the leverage ratio is becoming more of a binding constraint than a backstop. That’s because events beyond banks’ control are causing their reserves to rise sharply. For one, the Fed’s securities purchases, aimed at stimulating the economy, are pumping hundreds billions of dollars into sellers’ accounts. Also, the Treasury Department is rapidly spending down funds it accumulated to execute the government’s Covid-19 relief packages. Together, these should bring reserves to more than $5 trillion by this summer — up from $1.7 trillion before the pandemic hit, and enough to push some banks close to the 5% limit.

Fed officials recognize that this isn’t a good outcome. By constraining balance-sheet growth at banks, it undermines the central bank’s efforts to encourage lending. And it creates an artificial incentive for banks to allocate the assets they have toward riskier, higher-return investments, rather than toward safer investments such as Treasury securities and the short-term collateralized loans known as “repo” transactions. Yet the Fed and other regulators nonetheless allowed a temporary relief measure — which exempted reserves and Treasury securities from the leverage ratio calculation — to expire on March 31.

The large banks most affected by the leverage ratio can probably manage as its grip tightens. At the margin, they can keep their balance sheets from growing by pushing unwanted corporate deposits to other banks, or by competing less aggressively for household deposits. If needed, they can bolster their capital by issuing preferred stock or delaying share buybacks. 

But why wait to see how bad the situation gets? And why encourage banks to reject deposits? As direct obligations of the central bank, reserves are as safe as assets can be. The Fed, not the banks, determines the quantity of reserves in the system. So why not address the frictions caused by the more-binding leverage ratio by reinstating the exemption for reserves?

Some worry that a permanent exemption would allow banks to operate with less capital overall. This is a legitimate concern: Banks should have adequate loss-absorbing equity so they can keep lending even in difficult times. But it’s easily addressed. Simply offset the effect of the exemption by raising the leverage ratio. If, for example, bank reserves comprised 10% of total assets, the minimum leverage ratio should increase by 10% — from 5% to 5.5% — to render the requirement for other assets unchanged. Alternatively, the Fed could exempt only the incremental reserves that have accumulated since it began its latest securities purchase program in March 2020.

As it stands, the leverage ratio is working at cross purposes to the Fed’s monetary policy. With such an obvious solution available, there’s no good reason to dither.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

©2021 Bloomberg L.P.

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