Federal Reserve eases capital rule to encourage bank lending

The Federal Reserve has eased a capital rule for large banks in a move to encourage leading financial groups to increase lending and play a bigger role in the market for US Treasuries.

The “supplementary leverage ratio”, a rule adopted in 2013, required large banks with international portfolios to hold capital — equal to 3 per cent of their total assets — to absorb losses. On Wednesday the US central bank said banks could exclude Treasuries and cash reserves held at the Fed from these calculations for a year.

The decision means that as the Fed pushes more cash reserves into the banking system, the banks will be able to take those reserves on to their balance sheets without having to increase capital at the same time.

“If [the capital rule] was a binding constraint to banks, we just created capacity to lend money,” said Peter Fisher, former head of the Fed’s market desk, now at Dartmouth’s Tuck School of Business. Banks should “no longer be bound and therefore have latitude to lend’’.

Priya Misra, global head of rates strategy at TD Securities, said with the new rule, banks would be more likely to buy Treasuries if they cheapen sufficiently, helping to ensure the smooth functioning of the world’s largest debt market.

“This is a very big deal,” she said. “Now we don’t have to rely on just the Fed to bring normalcy back to the Treasury market . . . There’s an additional player that can restore normalcy.”

Strains emerged in the $18tn US government bond market in March, as the coronavirus outbreak morphed into a global pandemic and sent financial markets tumbling. Trading conditions deteriorated significantly, and volatility surged to its highest level since the global financial crisis, according to a Bank of America metric based on options prices. 

Investors had pinned some of the blame on the regulatory rules put in place in the last decade, arguing that they discouraged banks from storing assets on their balance sheets and facilitating trades.

“The change to the supplementary leverage ratio will mitigate the effects of those restrictions and better enable firms to support the economy,” the Fed said.

According to Ms Misra, the rule change will help to ensure the emergency measures already announced by the Fed will work more effectively. In recent weeks the US central bank has rolled out a variety of new facilities aimed at restoring order to financial markets and protecting against the worst of the economic destruction brought on by Covid-19. 

On Tuesday the Fed announced it would allow central banks and international monetary authorities to exchange Treasuries for dollars, in a bid to not only ensure the Treasury market remains fully functional, but to also bring some relief to countries seeking access to dollars.

The Fed has also committed to support the markets for corporate debt, municipal debt and commercial paper, as well as to buy an unlimited quantity of Treasuries and agency mortgage-backed securities.

“Bank balance sheet was the biggest constraint for the facilities,” Ms Misra said. “This was the final frontier.”

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