SLR reform and the ‘doom loop’ | USAEMALL.com

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Good morning. Well, that escalated quickly: regular readers will be familiar with the acronym Taco — Trump Always Chickens Out — which this newsletter coined some weeks ago. Yesterday, someone asked the president about it at a White House press conference. He didn’t seem to like it all that much. The problem for Unhedged (other than an increased risk of getting audited this year) is that we like it when Trump chickens out on his tariff threats. Chickening out from bad policy is good. But now that Trump knows about the Taco trade, is he less likely to chicken out? This was not our plan! At all! Email us and we will apologise to you directly: [email protected]. 

SLR reform

Last week, we wrote about the supplementary leverage ratio (SLR), one of the broadest capital ratios used to regulate US banks. We offered conditional support for the idea of adjusting the SLR requirements for Treasuries — meaning banks would not need to hold as much capital against Treasuries and could therefore buy more of them. We still think this proposal makes sense, insofar as it helps with liquidity in the Treasury market. But we are also concerned about the timing of the change and the motives behind it. 

As Treasury secretary Scott Bessent has noted, allowing banks to buy more US debt would support the Treasury market. At the same time, the administration also lent its support to the Genius act — which encourages stablecoin issuers to hold T-bills. Taken together, the two initiatives look a lot like an effort to support domestic demand for federal debt at the very moment that foreign buyers appear to be stepping away.

There is nothing inherently wrong with an administration trying to bring down US borrowing costs. But there are costs associated with going about it this way. The first, according to Steven Blitz, chief US economist at TS Lombard, has to do with the purpose of banks in the first place:

[If the banks hold more Treasuries], the banks start to look a lot more like institutions that intermediate funds between depositors and the federal government, as opposed to between depositors and the private sector . . . What that means is that the growth generation is more and more in the hands of the government than the private sector, which is the opposite of what Republicans have historically wanted to do.

Much depends on how the SLR is specifically adjusted. But one could imagine a scenario where banks end up seeing Treasuries as providing one of the highest, or the highest, risk-adjusted returns on equity capital available. While that would certainly lower Treasury yields, it could also decrease lending into the real economy. Also, as Blitz pointed out to Unhedged, banks have a preference for short-term T-bills, over longer-duration Treasuries. An adjustment to the SLR may not lower benchmark 10-year yields, which the government appears to be after, as much as it would lower shorter-term yields and steepen the yield curve.

The biggest risk, however, could be structural. As we learned during the rolling European debt crises of the 2010s, a country’s banks owning too much of its sovereign debt can result in a “doom loop”. If there is a jump in sovereign bond yields, banks will see their equity cushion grow thinner as bond prices drop — causing the banks to pull back from lending, a drag on the economy. In a weaker economy, this can result in a vicious circle, where the banks’ weakness means they will no longer buy debt from a sovereign that badly needs to raise new capital, and the banks may need support at just the moment the government is least able to provide it.

The US is not going to enter this sort of debt spiral any time soon. According to Blitz, US banks own about 6 per cent of the US’s outstanding debt — low by historical standards, and below the proportion of Italian sovereign debt owned by Italian banks in recent crises. And, as Ignazio Angeloni at the European University Institute notes, the structures and conditions of the European and American monetary systems are different, particularly in the case of Italy:

There was an issue in Italy with sovereign default risk . . . Italian debt levels were much higher, and Italy is part of a monetary union. Italy cannot print money or monetise the debt . . . Debt levels are rising [in the US], but we are not there yet. And the Fed is still strong and independent. It can always pay.

All that said, we are at a delicate economic moment. It appears that foreign demand for US Treasuries is waning; Congress just passed a massive spending bill, causing bond market trepidation; and the Fed has a tense relationship with the White House. In the longer run, adding a thick layer of Treasuries to bank balance sheets could lead to dangerous feedback loops.

In the shorter term, high exposure to longer-term Treasuries carries real risks for the banks themselves. The collapses of Silicon Valley Bank and First Republic Bank demonstrated that high duration — sensitivity to interest rates — can help spur bank runs. Rates are already high relative to recent history, but long-dated yields are rising, and stagflation remains a possibility. It might not be a great moment to push 10-year Treasuries on banks.

There are good reasons to adjust SLR requirements on Treasuries, and maybe reserves held at the Fed. But any reforms should be measured, and potentially offset by risk-based capital requirements; and regulators should take into account the simultaneous impacts of the Genius act. 

And we should keep our expectations in check. SLR reform’s backers at the Fed are concerned with liquidity in the Treasury market at moments of stress. Its backers at the Treasury department are more concerned with US debt sustainability and Treasury yields. SLR reforms could help with both issues. However, the evidence is mixed for the former, while the latter has its own unique risks and will probably make more of an impact on T-bills than T-bonds. And neither will make that much of a difference in the face of rising deficits, slowing growth or attacks on Fed independence.

(Reiter)

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