The intention of the Trump administration to modify the Enhanced Supplemental Leverage Ratio (ESLR) of banks marks the beginning of a series of possible direct and indirect reductions in capital requirements proposed by federal banking regulators. The leverage ratio, which includes the ESLR, represents the minimum capital that banks must maintain as a percentage of their assets, independent of the risk associated with these assets. This ratio complements risk-based capital standards, which require banks to maintain more capital as the risks of their assets increase.
The modification of the ESLR is one of the few proposals that has received support from those advocating for robust capital requirements. The main reason is the potentially negative impact of the current ESLR on the functioning of the U.S. Treasury bond market, especially in a context of increasing U.S. public debt. In summary, the current ESLR, applied to the eight most important banking institutions in the system (G-SIBs), could limit the ability of banks to buy Treasury bonds in times of market stress.
Supporters of strong capital requirements argue that a relaxation of the ESLR should be accompanied by an increase in risk-weighted capital requirements, with the aim of maintaining the level of resilience achieved by the G-SIBs since the Global Financial Crisis. However, it is unlikely that banking regulators will adopt this measure robustly. Nevertheless, it is crucial that they recognize the vulnerability of some Treasury bond holdings of banks to market risk.
Political Decisions
In this context, it is essential to make informed political decisions about how to relax the ESLR in a second or third best scenario. Banking regulators should not simply exclude Treasury bonds and central bank reserves from the denominator of the ESLR. Instead, they should reduce the minimum ESLR to allow for greater Treasury bond buying by the largest U.S. banks, while at the same time preserving the purpose of the leverage ratio to protect against unexpected changes in the value of traditionally secure assets.
The current ESLR, imposed on the eight most important banking institutions in the U.S. banking system (G-SIBs), could limit the ability of banks to buy Treasury bonds in times of market stress. This restriction arises because the ESLR requires banks to maintain a specific percentage of capital in relation to their total assets, including Treasury bonds and reserves at the Federal Reserve. Given that these assets are considered low risk, the ESLR could limit the ability of banks to buy more Treasury bonds, which is crucial for market stability.
The main concern is that, in times of financial stress, banks could need to sell their Treasury bond holdings to meet capital requirements, which could trigger a fall in Treasury bond prices and an increase in interest rates. This not only affects the stability of the Treasury bond market, but also has wider implications for the economy, as interest rates are a key factor in financial and economic decision-making.
Risk Mitigation
To mitigate these risks, some proponents propose a relaxation of the ESLR that allows banks to hold more Treasury bonds in their portfolios without compromising their financial resilience. However, this relaxation must be done in a way that does not undermine the integrity of the financial system.
A possible solution is to reduce the minimum ESLR, which would allow banks to increase their Treasury bond holdings without significantly reducing their available capital for other purposes. This relaxation could also be accompanied by an increase in risk-weighted capital requirements.
This balanced approach would ensure that banks maintain an adequate level of capital to deal with the risks associated with their assets, even in a lower ESLR environment. In this way, financial system stability could be maintained while allowing banks to participate more actively in the Treasury bond market.
It is crucial that banking regulators consider not only the immediate implications of any change in the ESLR, but also the long-term implications for financial system stability. The decision on how to relax the ESLR should be based on a comprehensive analysis of risks and benefits, and should be taken with the aim of promoting financial stability and bank resilience.
Conclusion
The modification of the ESLR is a complex proposal that requires a balanced approach. Regulators must ensure that any change in the ESLR does not compromise the resilience of the financial system, while at the same time allowing banks to participate more actively in the Treasury bond market. This will involve a careful adjustment of the minimum ESLR and a possible increase in risk-weighted capital requirements, to ensure that banks are well capitalized and can deal with the risks associated with their assets.
