Fed Stress Test Finds U.S. Banks Not Healthy Enough To Withstand “Few Quarters” Economic Downturn
In its annual stress test, the Fed said the nation’s biggest banks are healthy but could suffer 2008-style losses if the economy languishes. Fed Stress Test Finds U.S. Banks Not Healthy Enough To Withstand “Few Quarters” Economic Downturn
The Federal Reserve on Thursday said a prolonged economic downturn could saddle the nation’s biggest banks with up to $700 billion in losses on soured loans and ordered them to cap dividends and suspend share buybacks to conserve funds.
In a worst-case scenario, where unemployment remains high and the economy doesn’t bounce back for a few quarters, the 33 largest U.S. banks would suffer heavy loan losses that would erode the capital buffers meant to keep them on stable financial footing, the Fed said when it announced the results of its annual stress tests.
Designed to gauge the health of the nation’s banking system, the stress tests were expanded this year to study the effect of the downturn brought on by the coronavirus pandemic. The Fed said U.S. banks are strong enough to withstand the crisis and restricted dividend payouts and buybacks to make sure they stay that way.
Banks, which will announce their dividend plans for next quarter as soon as Monday, won’t be able to make payouts that are greater than their average quarterly profit from the four most recent quarters.
The Fed also barred them from buying back shares in the third quarter. Most of the largest banks had previously agreed to halt buybacks during the second quarter. Buybacks are the main way U.S. banks return capital to shareholders.
In a sign of the uncertainty facing the industry, the Fed required banks to resubmit updated capital plans later this year to reflect current stresses.
The central bank didn’t break out the results of the coronavirus analyses for individual banks. However, among the six largest, only Wells Fargo & Co. had a dividend payout that would breach the new threshold set by the Fed, according to Wolfe Research forecasts. The bank’s dividend in the third quarter would be 150% of its average expected profits over the past four quarters. A Wells Fargo spokesman declined to comment on the stress test results.
The Fed said limiting shareholder payouts would help keep banks healthy during the recession. Its analysis of the current pandemic found that if the economy takes a long time to recover, banks could experience losses similar to the financial crisis of 2008.
Banks could suffer losses on consumer debt such as auto loans and mortgages, as well as corporate debt and commercial real estate. Most of the firms would remain well capitalized, but some would approach their minimum capital levels.
Randal Quarles, the Fed’s point man on financial regulation, said the central bank could take additional steps to restrict buybacks or dividends “if the circumstances warrant.”
The Fed’s decision to allow banks to keep paying dividends during the crisis drew a sharp dissent from Lael Brainard, the Fed’s lone holdover from the Democratic Obama administration. Allowing banks to “deplete capital buffers,” she said, could force them to tighten credit in a protracted downturn.
“This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery,” she said in a statement. “This policy fails to learn a key lesson of the financial crisis, and I cannot support it.”
Former Fed officials and Democratic lawmakers have urged the central bank to prohibit both buybacks and dividends to ensure the firms could continue to lend if the economic fallout from the pandemic worsens.
Daniel Tarullo, who oversaw bank regulation at the Fed from 2009 until 2017, said Thursday’s moves “don’t really amount to much” and reflect a “substantial erosion” in the value of the annual tests.
The Fed ought to have taken the time to recalibrate this year’s tests to reflect the actual coronavirus shock, rather than adding analysis that “apparently was not good enough to release on a bank-by-bank basis to the public,” but is nonetheless being used to inform bank capital policies during the third quarter.
The Fed annually releases a scenario for an economic catastrophe and then looks at banks’ ability to withstand it.
The results, which were broken out by individual banks and released Thursday, were largely as expected. But this year’s scenario was quickly overshadowed by the pandemic, whose economic effects were far worse.
After coronavirus ground the U.S. economy to a halt in March, the biggest U.S. banks set aside billions of dollars to cover a wave of expected loan defaults. In the months since, a period that saw unemployment surge to a post-World War II high, Americans skipped more than 100 million debt payments.
A gradual reopening of stores, restaurants and factories in recent weeks has given the economy a much-needed boost. But a recent surge in coronavirus cases in big states like Arizona, Texas and Florida has clouded the outlook.
Reflecting the uncertainty about how the economy will fare in the year to come, the Fed’s analysis looked at three extreme scenarios to gauge their effect on banks. The first was a “V-shaped” recovery, in which the economy bounces bank rapidly from a severe downturn. That would result in nearly $560 billion in loan losses across the nine-quarter period that the Fed studied.
A more prolonged downturn that led to a “U-shaped” recovery would cause $700 billion in loan losses. A “W-shaped” recovery in which the economy bounces back quickly but then takes another dip, would result in $680 billion in loan losses.
The analysis excluded capital distributions that were already planned and didn’t take into account government efforts to support the economy, such as expanded unemployment benefits and the Paycheck Protection Program.
Biggest U.S. Banks Seen Adding To Reserves For Pain Yet To Come
When it comes to loan losses sparked by the Covid-19 pandemic, U.S. banks aren’t taking any chances.
The nation’s four biggest lenders probably set aside about another $10 billion for bad loans in the third quarter, according to analysts’ estimates compiled by Bloomberg, even though stimulus moves by the government and Federal Reserve have so far staved off a spike in missed payments.
While the third quarter’s tally is well below the pace of the first half, it means that the banks will not only have covered the losses they’ve seen since the start of the pandemic, but also added almost $50 billion to reserves for future pain.
Investors’ big question will be whether that comes from typical caution, or if the banks are seeing worrying signs as forbearance programs wind down and stimulus efforts get bogged down in a partisan fight.
“There is still an enormous amount of uncertainty about how this will ultimately unfold, particularly for the consumer,” JPMorgan Chief Financial Officer Jennifer Piepszak said last month. But she added that “things are looking better than we would have thought.”
As giant lenders including JPMorgan Chase & Co., Bank of America Corp., and Wells Fargo & Co. report third-quarter results this week, analysts expect a slight uptick in net charge-offs as some loans sour.
That will still be outstripped by banks’ provisions as they prepare for losses from industries hurt by lockdowns and consumers who are unemployed. Already in the first half, JPMorgan added $6.6 billion to its reserve for credit-card losses, while Wells Fargo boosted its commercial-loan reserve $6 billion.
Piepszak said the bank’s provisions are based on economic assumptions that are more severe than what its economists expect to happen, and the company wasn’t predicting a meaningful reserve build or release in the third quarter.
Bank of America Chief Executive Officer Brian Moynihan said last month that reserves and charge-offs would probably be “modest.” And Citigroup CFO Mark Mason said the bank expected additional reserve increases would be “meaningfully lower” than earlier in the year.
Betsy Graseck, an analyst at Morgan Stanley, estimated that loan-loss provisions declined about 61% from the second quarter. “It’s hard to know how low provisions will go, as reserve builds should be close to complete,” Graseck said, adding that the most recent unemployment rate of 7.9% is well below the roughly 9% year-end estimate that most banks used to build reserves.
Banks may be setting aside more than they need for loan losses to take advantage of strong trading revenue and the fact that they can’t return excess capital to shareholders. The Fed this month extended through the rest of the year its unprecedented constraints on dividend payments and share buybacks for the biggest U.S. lenders.
Here are some other key indicators to watch when JPMorgan and Citigroup kick off earnings week on Tuesday:
Trading will probably again drive big revenue gains for banks, as volatility sparked by the pandemic boosts demand from investors moving in and out of stock and bond holdings. Firms recorded a surge in the business last quarter, with the five largest U.S. banks hauling in a total of $33 billion.
JPMorgan’s revenue from trading probably jumped 20% from a year earlier, Piepszak said last month. Moynihan at Bank of America estimated an increase of 5% to 10%, and Mason said Citigroup’s figure probably climbed by a percentage in the low double digits.
Trading activity remained elevated through the third quarter, James Mitchell, an analyst at Seaport Global Securities, said in a note. Mitchell cited “particular strength in global equities volumes” last month.
Revenue at the five banks is expected to jump 16% from last year to $22.3 billion, according to analysts’ estimates compiled by Bloomberg. JPMorgan probably posted the biggest haul, at $6.2 billion, followed by Citigroup and Goldman Sachs.
Net Interest Income
Net interest income — the difference between what banks charge borrowers and what they pay depositors — is expected to have continued falling in the third quarter as near-zero interest rates hurt margins.
Lower short-term rates will crimp banks’ income from lending more than it will lower their deposit costs, analysts at Goldman said in a report last week. Net interest income will decline by about 3% for the largest banks from the previous quarter, according to Goldman.
Even though the yield curve has steepened, meaning the spread between short-term and long-term rates increased, that does little to help banks’ margins because most loans are priced at spreads to Libor or similar short-term benchmarks. Banks are hard-pressed to narrow those spreads when interest rates are low, creating a slow grind on interest income over time.
The average net interest margin for U.S. banks dropped to an all-time low of 2.89% in the second quarter, according to Federal Reserve data going back to 1984. The average for the biggest four lenders was 2.2% in the period. It will probably drop to 2% in the third quarter, according to Goldman estimates.
Wells Fargo just eliminated more than 700 commercial-banking jobs, pursuing a plan of workforce reductions that could eventually number in the tens of thousands, people with knowledge of the matter said last week.
The bank is the industry’s biggest employer, but more widespread job cuts are coming as banks abandon their no-layoff policies put in place as the pandemic began to intensify earlier this year. Wells Fargo, Citigroup, JPMorgan and Goldman Sachs are all trimming staff. Bank of America is standing by its pledge through the end of the year, Moynihan said earlier this month.
With firing freezes in place and new employees still joining, headcount at the six biggest banks rose by almost 17,000 in the first half. That was the biggest increase since the mergers of the financial crisis.
With banks sitting on a mountain of deposits, investors have been eager to see how they’ll be deployed. There’s at least one area firms have already shown an appetite for: credit cards.
Assets tied to credit-card loans and other revolving forms of credit were down about 6.3% in August, which is better than the 34% decline banks reported for the end of the second quarter, according to data compiled by the Fed.
And more improvement could be on the horizon. Lenders mailed out 150 million card offers to consumers in August, a 56% surge from the previous month as “industrywide volume has continued to bounce back from the low in June,” Moshe Orenbuch, an analyst at Credit Suisse Group AG, said in a note to investors.
Federal Reserve To Test Ability Of Largest Banks To Weather A Recession
Stress test will feature a scenario in which markets seize up and unemployment jumps above 10%.
The Federal Reserve said it would test the ability of the largest U.S. banks to weather a hypothetical recession in which markets seize up and unemployment jumps above 10%.
The so-called stress test, conducted annually to see how banks would react to dramatic market and economic shocks, will feature a scenario in which a severe global recession leads to “substantial stress” in commercial real estate and corporate debt markets, the Fed said.
In a “severely adverse” scenario, unemployment rises by 4 percentage points to reach nearly 11% in the third quarter of next year, as gross domestic product falls and asset prices drop sharply, including a 55% decline in equity prices.
Designed to gauge the health of the nation’s banking system, the stress tests were expanded last year to study the effect of the downturn brought on by the coronavirus pandemic. The Fed said in June that U.S. banks were strong enough to withstand the crisis and restricted dividend payouts and buybacks to make sure they stay that way.
The tests assess whether a bank has sufficient capital to withstand a severe downturn and to make four quarters of planned shareholder dividends. If a bank misses that target, it faces automatic restrictions on dividends and buybacks unless it raises additional capital.
The biggest banks in America—a group that includes JPMorgan Chase & Co. and Goldman Sachs Group Inc. —must do well on the tests to return money to shareholders.
In a second round of tests last fall, the Fed again found banks were healthy enough to survive the coronavirus crisis but warned that a prolonged economic downturn could saddle them with hundreds of billions of dollars in losses on soured loans.
“Although uncertainty remains, this stress test will give the public additional information on its resilience,” Randal Quarles, the Fed’s vice chairman of supervision, said in a statement on Friday. “The banking sector has provided critical support to the economic recovery over the past year.”
Fed Trapped By A Covid Exemption For Bank Leverage
Debate over the emergency measure raises uncomfortable questions about the Treasury market.
Credit Suisse says it’s no “magic bullet.” Bank of America insists it’s a “red herring.”
And yet all it takes to whip bond traders into a frenzy is the mention of a three-letter acronym — SLR.
That stands for supplementary leverage ratio, a requirement stemming from the Basel III accord that says U.S. banks must maintain a minimum level of capital against their assets without factoring in risk levels.
As a way to push banks to help the country get through the Covid-19 pandemic, regulators allowed them to temporarily exclude U.S. Treasuries and deposits at the Federal Reserve from the SLR denominator because they are the closest thing to risk-free assets.
In addition to helping banks continue to take deposits and lend during the health crisis, it also served to ensure they would help backstop the unprecedented fiscal and monetary policy support that flooded the financial system with cash.
This emergency move is set to expire on March 31 — and the Fed has been unusually silent about the SLR’s fate ahead of its policy decision next week. Jelena McWilliams, chair of the Federal Deposit Insurance Corporation, said last week that she doesn’t see the need to extend the interim rule at the depository institution level, according to Politico.
Because the FDIC, Fed and the Office of the Comptroller of the Currency collectively approved the measure last year, markets have taken McWilliams’s stance as effectively ruling out a widespread extension. Even though she said the most important question rests with the Fed, which regulates the parent holding companies, that’s not quite right either, Mark Cabana, head of U.S. rates strategy at Bank of America, told me in an interview, because holdings of Treasuries went up significantly at depositories over the past year, not dealers.
It makes sense why Cabana calls the SLR debate a “red herring.” It’s inherently complicated and requires a deep understanding of the private banking system and how the Fed’s balance sheet works — beyond the “money printer go brrr” meme. When digging in, it becomes clear that the Fed has no easy solutions to maintain a healthy banking system and Treasury market.
First, it’s important to understand the mechanics behind the Fed’s bond-buying program. When it purchases Treasuries from a money manager, those securities become an asset on the central bank’s balance sheet. The seller will deposit the cash it received at a bank, which, left as reserves at the Fed, is an asset for that bank and a liability for the Fed. In other words, quantitative easing boosts the asset levels of U.S. banks, which, in turn, means they need to hold more capital.
There’s nothing wrong with the Fed, as a regulator, requiring that banks maintain adequate capital to avoid another financial crisis. But it’s a hard sell when the Fed, as the nation’s monetary policy authority, is forcibly increasing the asset base.
This kind of internal struggle explains why the SLR exemption was put in place; it’s anyone’s guess what might have happened without it as the Fed expanded its balance sheet by almost $3 trillion in three months.
So, what to do? At first glance, the easy answer seems to be to just extend the SLR exemptions for Treasuries and reserves to avoid disrupting this market plumbing. By some measures, this break allowed banks to expand their balance sheets by as much as $600 billion — why mess with that?
However, the Fed created its own political problem by loosening its restrictions on banks’ cash distributions, which had been put in place after the pandemic. Banks are now buying back stock and distributing capital to shareholders, or, in SLR terms, willfully reducing their numerator. It stands to reason, then, that they could afford to have the denominator return to its usual form.
This is the argument from Democratic Senators Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio. In a letter to regulators last month, they argued “to the extent there are concerns about banks’ ability to accept customer deposits and absorb reserves due to leverage requirements, regulators should suspend bank capital distributions. Banks could fund their balance sheet growth in part with the capital they are currently sending to shareholders and executives.”
Another problem with extending the SLR exemption is that it truly benefits only a few large banks, 1 as Zoltan Pozsar, a strategist at Credit Suisse, noted during a recent Bloomberg “Odd Lots” podcast.
Not only is such favoritism politically fraught, but it runs the risk of falling short of what’s necessary to absorb the amount of cash hitting the financial system. The SLR exemption is talked about as a “magic bullet,” he said, but that’s not really the case.
“Maybe only reserves should exempted permanently, but not Treasuries — that would be more in line with the global standard,” Pozsar said, floating an idea that has been bandied about by strategists. But that creates new issues in short-term rates markets.
Specifically, when overnight repo rates climb above the Fed’s interest rate on excess reserves, or IOER, banks have a natural incentive to use their cash to step into the repo market and capture a higher return.
That behind-the-scenes arbitrage might not happen if only reserves were exempt from SLR calculations because Treasuries typically serve as collateral for repo transactions. In such a circumstance, “there’s regulatory benefit to holding cash,” Cabana said, and banks would be less likely to serve as the “repo police.”
It has been less than two years since the repo meltdown of September 2019, which JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon blamed in part on regulations, and the Fed isn’t eager for a repeat performance.
Dimon, for his part, raised the specter of having to turn away deposits at some point without SLR relief during the bank’s earnings call in January, which would obviously be quite a drastic business decision. In response to the same question, Chief Financial Officer Jennifer Piepszak described the whole situation rather bluntly:
“Obviously it is an issue for us in the near to medium term, should we not get the extension and it’s one that’s important for people to understand. But we bring it up more so, because it’s another example of where lack of coherence around this, that these rules can have an impact, not just on JPMorgan.
So we don’t bring it up, just because of the impact on JPMorgan. We bring it up because it is perhaps one of the better examples of the need for recalibration. You have to have the right incentives in the system for it to work through time.
And we’re just seeing that, that’s not the case.”
These are the leaders of the largest U.S. bank saying the Fed has a serious problem. To Cabana, the recent angst over the SLR extension has less to do with the actual mechanics and is more about the rapid increase in Treasury yields over the past two months, which happened to coincide with the expiring exemption.
“What all of this indicates to me is there’s heightened sensitivity over where Treasury demand is going to come from and whether Treasury rates can remain here,” he said. “Because there’s a lot of debt out there, and it’s only going to keep growing.” The U.S. is auctioning $38 billion of 10-year notes on Wednesday and $24 billion of 30-year bonds on Thursday.
It’s rare for the Fed, arguably the most powerful financial institution in the world, to look as if it’s trapped. Not granting an SLR extension, especially with traders so focused on it, runs the risk of pushing up Treasury yields, which at a certain point could hamstring the recovery and jeopardize its goals.
Extending the exemptions is bad optically, will draw political opposition and might not even resolve underlying issues with the financial plumbing and the growing size of the Treasury market. It’s not clear there’s better middle ground, though Bank of America’s suggestion to allow reserves and Treasuries accumulated during the pandemic to be exempted could potentially do the least damage.
Whatever the Fed decides to do, it won’t be a panacea and it won’t be a disaster. But it’ll likely be messy. For central bankers who are used to being in control, that’s equivalent to a no-win situation.
Ex-Fed Employee Admits To Stealing Bank Stress-Test Data
A former Federal Reserve employee admitted to illegally taking documents, including bank stress test data, after deciding to leave the board, U.S. prosecutors said Friday.
Venkatesh Rao, 67, pleaded guilty Thursday in federal court in Maryland to a single charge of theft of government property. In 2019, Rao entered the Federal Reserve building in Washington over several weekends and printed more than 50 restricted documents, which contained information used by the board to conduct stress tests.
Rao, who at the time was voluntarily separating from the board after receiving a poor performance evaluation, took the documents to his home in Bethesda, Maryland, according to a plea agreement.
Court records don’t explain what Rao intended to do with the information or whether any of that data was given to anyone outside of the government. Rao, who’s scheduled to be sentenced in May, faces as much as a year in prison.
Rao’s lawyer, G. Allen Dale, said in an interview that his client did nothing with the documents he copied, noting that he was the author of everything he had printed. Dale also pointed to the misdemeanor charge Rao pleaded to as evidence the government wasn’t accusing him of having more nefarious intentions.
The Fed’s annual stress tests are among the central bank’s top oversight tools, meant to ensure the financial industry can weather a severe crisis. The agency is famously guarded about the data it reveals to the institutions being tested.
Federal Reserve To End Emergency Capital Relief For Big Banks
Move disappointed Wall Street firms that had pressed for an extension to the relief.
The Federal Reserve said it was ending a yearlong reprieve that had eased capital requirements for big banks, disappointing Wall Street firms that had lobbied for an extension.
Friday’s decision means banks will lose the temporary ability to exclude Treasurys and deposits held at the central bank from lenders’ so-called supplementary leverage ratio. The ratio measures capital—funds that banks raise from investors, earn through profits and use to absorb losses—as a percentage of loans and other assets.
Without the exclusion, Treasurys and deposits count as assets. That will likely force banks to hold more capital or reduce their holdings of those assets, both of which could ripple through markets.
Analysts have been keying on the issue, which is widely viewed on Wall Street as carrying potential implications for markets from bonds to stocks to commodities.
Some analysts had warned that the exemption’s sunset could add to volatility in the $21 trillion market for U.S. government bonds at a time when Wall Street is concerned that heavy debt issuance to pay for federal stimulus spending and other Biden administration priorities would amplify the 2021 increase in Treasury yields.
But the Fed said it would consider a broader revamp of the rules and banks aren’t immediately expected to change their activity, tempering the market reaction Friday. The yield on the 10-year Treasury note was roughly unchanged at midday Friday, as were the major stock indexes.
“This is not a disastrous outcome, but it is not optimal in our view either,” said Krishna Guha, vice chairman of Evercore ISI, an investment banking advisory firm.
The Fed said it would soon consider ways to recalibrate the leverage ratio and its treatment of ultrasafe assets. Without more permanent changes, banks may over time have a perverse incentive to load up on riskier assets, because the ratio is risk insensitive, meaning it treats ultrasafe assets the same as junk bonds, Fed officials told reporters.
“Because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability,” the Fed said in a statement.
The Fed stressed that overall capital requirements for big banks wouldn’t decline after any recalibration.
Large lenders aren’t facing an imminent cliff on March 31, when the exemption ends, because their capital levels aren’t so close to the threshold that the changes will put them overboard, large bank executives said.
Instead, the lenders will have time to see how the Fed’s current market interventions play out and how customers react with their deposits over the summer months, when the economy is expected to recover quickly.
They will also be watching regulatory guidance on what the permanent changes would be, and how fast they could be in place, before making significant changes to their own operations, one executive said. The chance of a permanent fix was viewed as a positive because it means the worst of the problems will likely be avoided, the person said.
Banks have a range of levers they can pull as they get close to their capital levels, but it will depend on where the pressure is on their balance sheets.
Among the most likely moves, and one they have deployed in years after the 2008 financial crisis, is to threaten some big corporate depositors with fees for parking their cash. The deposits that have flooded the banks over the past year are unprofitable for banks and considered too short-term to lend out. To fix the problem, the banks could threaten negative interest rates on those deposits in an attempt to drive them away.
On their quarterly conference call with analysts in January, JPMorgan Chase & Co. executives warned they could be forced to push away clients, issue new debt or reduce shareholder payouts if the Fed didn’t extend the relief.
“Remember, we were able to reduce deposits $200 billion in like months last time,” Chief Executive Jamie Dimon said on the call. “But we don’t want to do it. It’s just very customer unfriendly to say ‘please take your deposits elsewhere.’”
The central bank adopted the temporary exclusion a year ago in an effort to boost the flow of credit to cash-strapped consumers and businesses and to ease strains in the Treasury market that erupted when the coronavirus hit the U.S. economy. The market has since stabilized.
Treasury issuance has soared along with federal government deficits since the start of the pandemic, as businesses across the country shut down and laid off millions of workers, and the government ramped up spending to cushion the economy and combat the coronavirus.
The Congressional Budget Office last week projected the deficit for the current fiscal year will total $2.3 trillion, nearly a trillion dollars less than the record-setting gap last year, but more than officials projected in September.
Friday’s decision became more complicated for the Fed after the issue became more of a partisan fight.
Senior Democrats such as Senate Banking Committee Chairman Sherrod Brown of Ohio and House Financial Services Committee Chairwoman Maxine Waters (D., Calif.) said before the Fed’s decision that an extension of the relief would be mistake, weakening the postcrisis regulatory regime. Republicans generally pressed for an extension.
Big U.S. banks must maintain capital equal to at least 3% of all of their assets, including loans, investments and real estate. By holding banks to a minimum ratio, regulators effectively restrict them from making too many loans without increasing their capital levels to cover potential losses.
The banks are sitting on giant stockpiles of cash, U.S. government debt and other safe assets. By tweaking how the ratio is calculated last year, the Fed was effectively trying to engineer a swap. Remove Treasurys and central-bank deposits from the calculation, the thinking went, and banks should be able to replace them in the asset pool with loans to consumers and businesses.
U.S. lenders saw their loan books increase about 3.5% last year, the slowest pace in seven years, according to research from Barclays using Federal Deposit Insurance Corp. data.
Fed To End Covid-19 Capital Break It Gave Wall Street Banks
The Federal Reserve will let a significant capital break for big banks expire at month’s end, denying frenzied requests from Wall Street.
In response to the pandemic, the Fed had let lenders load up on Treasuries and deposits without setting aside capital to protect against losses. That relief will lapse March 31 as planned, the Fed said in a Friday statement.
Though the regulator concluded the threat that Covid-19 poses to the economy isn’t nearly as severe as a year ago, the Fed also said it will soon propose new changes to the so-called supplementary leverage ratio, or SLR. The goal is to address the spike in bank reserves triggered by the government’s stimulus programs.
“Because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability,” the Fed said.
The expiration of the temporary capital break may disappoint banks and bond traders, as many industry analysts had wanted the Fed to extend the deadline for at least a few months, especially since the $21 trillion Treasury market has seen recent volatility.
Treasury dealers already have been exiting the market at a rapid clip — more than $80 billion was pulled in the last two weeks in advance of the central bank’s decision. But Fed officials believe the market is sufficiently stable and banks’ capital is high enough to return to the pre-pandemic requirement while the agency considers long-term changes.
The biggest U.S. banks have nearly $1 trillion in capital, meaning they are already above the $800 billion that they need to comply with the full SLR, according to Fed estimates. Lenders themselves will have to decide how much they want to exceed the agency’s minimum requirement.
With the Fed declaring banks to be well capitalized, there’s a chance it will no longer be able to justify its pandemic-spurred constraints on dividends. While the regulator already relaxed an earlier ban on stock buybacks, it’s still restricting shareholder payouts. Fed Chairman Jerome Powell said this week that a decision is coming soon on dividends.
Read more: Fed to weigh bank dividends after ending capital break
“This takes out of play the biggest political impediment to the Fed removing all Covid-19-related restrictions on big bank capital distributions,” Jaret Seiberg, an analyst for Cowen & Co., wrote in a Friday note. The Fed could drop its remaining constraints this year, he predicted.
Central bank officials provided no details on the permanent modifications they’ll propose to the SLR, but they did say they don’t want the industry’s overall capital levels to change. The Fed added that it will work with the other banking agencies: the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. Those regulators also announced Friday that they will let the temporary relief end March 31.
The agencies’ decision means big banks such as JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. must soon return to their customary SLR — a measure of their capital against all their assets.
“It’s a mistake,” Priya Misra, global head of rates strategy at TD Securities, said in a Bloomberg Television interview. “I don’t think the market was ready for this relief to be removed.”
The KBW Bank Index fell 1% as 2:12 p.m. in New York, with all but one of the 24 companies in the index slumping. JPMorgan declined 2.7%, the biggest drop on the index, followed by Wells Fargo & Co. at 2.2%.
The 10-year Treasury yield rose after the announcement, as many Wall Street strategists speculate the end of the regulatory break will induce some banks to shed Treasuries. The benchmark borrowing rate hovers at about 1.75%.
The Fed did provide another recent consolation, though, by more than doubling to $80 billion the maximum overnight reverse repo activity a participant can execute through the central bank’s facility. That could absorb some of the pressure of too much government stimulus cash sloshing through the system by giving money market funds a place to put it.
As Credit Suisse Group AG’s Zoltan Pozsar put it this week, the Fed is “foaming the runway” to deal with the stress of going back to the existing leverage rule by giving banks an additional ability to direct deposits into money market funds. Fed officials said Friday that move was a monetary-policy decision and not directly related to the leverage limit.
For the past year, that relaxed leverage cap had allowed the lenders to take on as much as $600 billion in extra reserves and Treasuries without bumping up their capital demand. The banks could now be under pressure to shed some of those assets or seek more capital.
JPMorgan has said it might consider turning away certain deposits as a result. And some Treasury market strategists expect a hit to the market as the biggest lenders potentially sell holdings.
The Fed faced intense political pressure from Democratic lawmakers, including Senate Banking Committee Chairman Sherrod Brown and Senator Elizabeth Warren, to let the capital break lapse March 31. While Democrats lauded Friday’s announcement, they will likely scrutinize the agency about its decision to propose permanent changes to the SLR. In a Feb. 26 letter to the Fed, Brown and Warren called it “one of the most important post-crisis regulatory reforms.”
Brown said in a statement Friday that ending the break is “a victory for lending in communities hit hard by the pandemic.” In a message on Twitter, Warren called it the “right decision for keeping our banking system strong.”
Ira Jersey, a rates strategist for Bloomberg Intelligence, predicted regulators will eventually let banks exclude reserves from their SLR calculations, but not Treasuries.
The leverage ratio, adopted as a key safety measure after the 2008 financial meltdown, has always been a three-agency effort. Though the Fed and OCC had proposed a wide-ranging overhaul in 2018, that project stalled. Fed officials said Friday they’ll work with the OCC and FDIC to determine what’s next. However, the Fed has been known to sometimes move independently on capital rules.
Fed’s Bank Leverage Decision May Start Taper Countdown
The central bank won’t extend its Covid-19 capital break in what could be a signal that it won’t buy $120 billion of bonds a month indefinitely.
After investors spent weeks brushing up on the specifics of the Federal Reserve’s Covid-19 era changes to the supplementary leverage ratio, the central bank ultimately decided it was best to just let those exemptions expire as intended on March 31.
The Fed and other regulators announced Friday that they wouldn’t extend an emergency move that temporarily allowed banks to exclude U.S. Treasuries and reserves at the central bank from the SLR denominator. All else equal, this reduces banks’ capacity to own Treasuries because they would have to put up more capital to do so, given the SLR doesn’t factor in the risk level of assets.
“The Treasury market has stabilized,” the central bank said in its own statement. “However, because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the Board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability.”
When comparing the two statements, it seems as if the Fed wasn’t quite pleased with the decision, which was politically fraught. It seems unlikely the SLR will simply revert back to its pre-pandemic calculation and stay that way forever.
But at least in the immediate future, banks can expect to be required to once again maintain a minimum level of capital against all of their assets, even deposits at the Fed, which the central bank itself is forcibly increasing by purchasing $80 billion of Treasuries and $40 billion of mortgage-backed securities each month.
As I noted in a column this month, the SLR debate trapped the Fed between its role as a regulator and the nation’s monetary policy authority. Now that it’s pulling back this capital break as a regulator, it’s only natural to wonder if it will soon start to prepare the markets for a tapering of its bond purchases, which would slow the huge growth in bank reserves.
After all, it’s not exactly a healthy development for the financial system when JPMorgan Chase & Co., the largest U.S. bank, warns about having to turn away deposits without SLR relief.
Now, Fed Chair Jerome Powell offered an emphatic “not yet!” during his press conference on Wednesday when he was asked about whether it was time to start contemplating tapering.
He and his colleagues have said it would require “substantial further progress” toward their goals of maximum employment and inflation that reached 2% and was on track to exceed it for some time before they would reduce the current pace of asset purchases. They have also said they’d provide guidance well in advance of such a move.
Still, bond traders have seen just how much can change over three months. Fed officials raised their growth estimates for this year to 6.5% this week from 4.2% in December. What might happen come June?
Rick Rieder, BlackRock Inc.’s chief investment officer of global fixed income, says the central bank may communicate plans to taper its asset purchases as soon as its June meeting, with the actual process potentially starting before the end of the year. In his view, the Fed could begin by slowing its buying of shorter-dated Treasuries while maintaining support for the longer-end of the yield curve.
This kind of timeline is hardly radical. The Fed is already bracing for some huge inflation numbers in the coming months because of comparison with figures from the same period a year ago. The movement in the central bank’s “dot plot” this week suggests that by June enough policy makers will see a rate increase by 2023 to lift the median estimate for the fed funds rate above the current 0% to 0.25% range.
Already, four officials are forecasting a rate hike in 2022. Given that the Fed has made clear that tapering will come before moving away from the zero lower bound, it certainly seems as if that group is on the same page as Rieder.
Meanwhile, other Fed officials who are more in line with Powell will wait to see actual data before changing anything about their monetary policy stance. Powell is optimistic, writing in an op-ed for The Wall Street Journal on Friday that “today the situation is much improved” and “I truly believe that we will emerge from this crisis stronger and better.”
But belief is no longer enough for the Fed — it now requires proof that the economy has indeed made “substantial further progress.”
At the same time, the entire SLR debate has served as a crucial reminder that the unprecedented monetary and fiscal support for the country during the pandemic isn’t without consequences. For one, the Fed still has much work to do when it comes to shoring up the resiliency of the Treasury and repo markets during periods of stress.
It’s not clear exactly what changes it might propose to the SLR that it couldn’t have put in place now. Most likely, it simply didn’t have buy-in from the Federal Deposit Insurance Corporation and the the Office of the Comptroller of the Currency.
Either way, without the SLR exemption in place, which by some estimates allowed banks to take on as much as $600 billion in extra reserves and Treasuries, the Fed’s current pace of bond buying is only going to strain the financial system. There may yet be a more permanent solution. But starting to “think about thinking about” tapering might also have to be part of the equation.
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