In monetary policy, the flow of money is comprised between four main counterparts: The US Treasury, the Federal Reserve, the Regional Banks, and the Consumers or Corporations.

The existing monetary policy is set up in integral checks and balances so that federal regulation is in place to prevent a catastrophic occurrence whenever an economic downturn occurs.

Therefore, the fiscal health of banks is always under scrutiny and intense transparency of its balance sheet.

What is the supplementary leverage ratio?

Banks in today's climate operate heavily under what is called a supplementary leverage ratio, or SLR.

What this ratio ultimately does is dictate how much loans it can give out to consumers, based on a percentage of financial assets they hold on their balance sheets concerning their equity or net profit on their balance sheet.

The minimum is usually at 3%, but more importantly, is what the federal regulators define as an asset.

Why does the SLR exist?

The SLR was put in place to prevent cases such as the 2008 Financial Crisis where banks were able to lend out freely in an environment where they did not have enough safe cash reserves to cover themselves when mortgage-backed securities defaulted.

Because of issues like this, federal regulators require a percentage and specifically mention what types of financial assets they must hold.

On a bank’s balance sheet, its assets are generally comprised of three main categories, loans or mortgage-backed securities, U.S. treasury securities such as Bonds, Bills, and Notes, and Balance Reserves, or earmarked cash that is required to be in a bank as an emergency fund for the chaotic economic climates as mentioned.

Historically the federal regulators have required that in the calculation of the supplementary leverage ratio, which is equity divided by assets, all three of these asset types must be included.

This meant that a bank’s total asset class could not be less than 3% of its net profit, and therefore it was incentivized that they either became more profitable in their banking practices, or reduce assets, whether it was to sell treasuries, reduce loan origination, or find a way to move cash off its balance sheet so long as it stayed above its reserve threshold.

Why Federal Regulators relaxed SLR rule

However, with the more recent economic climate due to the COVID-19 pandemic, federal regulators relaxed the ratio rule significantly that enabled banks for at least temporarily to change how to do business.

Regulators decided as a means for selling treasury yields that they would only require banks to report loans as assets for this ratio, which would dramatically increase their SLR, and enabled them to do two things.

One is they could issue more loans without concern of going below the minimum ratio so long as they kept their balance reserves at the appropriate minimum.

But more importantly, it gave them the incentive to buy US Treasury Securities because even at a low-interest rate they could obtain interest income from them, but more importantly, it would not impact their ability to push out loans to consumers so long as they had adequate reserves in their balance sheet.

The reason being the federal regulators were incentivized to do this was because, with high unemployment, there was a strong need to stimulate the economy at the peak of the pandemic to keep businesses afloat.

The Road to hell is paved with good intentions

What this ultimately meant was that to get money into the hands of corporations, citizens, and other institutions that needed financial assistance, the US Treasury had to print new money, which is secured by creating US Treasury securities.

These securities then could be passed on to the federal reserve, which would auction them off to regional banks, to raise cash.

The result of this monetary decision up to now was an overall net positive for both banks and the US economy.

For the economy, the inflow of money was crucial to keep money circulating throughout the nation, whether people were employed or unemployed.

As a result, even with still high unemployment numbers, many corporations were still showing profitable quarters and no significant slowdown in the business economy.

Banks ultimately took hits on balance sheets because treasury yields were low and loan originations were down due to limited performance in real estate.

With the economy starting to reopen again, however, banks are taking advantage of a limited window of opportunity.

With more money circulating in the economy and unemployment dropping, they are seeing a resurgence in profitability due to more loan requests as well as a steady rise in treasury yields for 2021.

However, because the supplementary leverage ratio rule has not been adjusted, there is a strong belief by some that there may be a dangerous moment coming.

There is a belief that at some point, this rule change may expire and require banks to start again reporting Treasury Yields and Balance Reserves as assets.

For some banks, which may have been close to the 3% requirement before COVID, the issuance of many new loans may have created a compliance issue because rediscovering these assets will force them to have to make major changes to their balance sheets to be within compliance once again. (3)

Some of the options they may have to consider are less lending to consumers, potentially negative rates to move assets over as liabilities or to begin selling to non-bank customers.

One of the easy fixes when selling to their clients is that because their clients held cash at their bank that acts as a liability, the bank could write off the deposits as well as the remaining balance of the loan to reduce the asset since the equation only applies to equity and not liabilities.

Additionally, they could also refrain from buying treasury securities for a while.

Alternatively, they could do things to improve profitably on the equity side. This can include using cash to buy back company stocks so that the bank holds more of its own equity or Tier 1 Capital.

They could also take on riskier mortgages or other derivatives that would ultimately increase their return and set them up more easily for bankruptcy due to the increased risk.

Finally, they could also look at their company's bottom line and make cuts to either operations or a shareholder dividend.

More importantly, the Biden administration has discussed openly raising corporate taxes, which could also affect these banks' bottom lines and so they may have to account for these forces as well.

Summary

In conclusion, the banks will keep hoping that these ratio rules are extended, but ultimately, they should expect at some point federal policy will force them to return to pre-covid leverage ratios.

Given that the loans and other private securitization are what makes banks the most money, having to pull back from profits will be disconcerting to management and shareholders.

Nevertheless, these banks will have to take one or more of three extreme actions.

First, they will have to consider finding more cash for assets. They simply cannot cancel loans and it will be difficult to ignore new loan requests. This means that they will need to find cash that can improve their equity position right away. Second, they will need to decrease liabilities.

This means finding ways to discourage their customers from depositing money into banks, as they would be obligated to pay the interest that eats into their profit margin.

Of course, the workaround is if they took out loans with their bank, in which case their liabilities could be written off the books.

Banks Need To Improve

Finally, the banks will need to improve their equity position however possible, whether its operational cuts, share buybacks, or other creative ways to improve their bottom line.

In today's economy, these monetary policies must be dealt with gently as any policy that forces banks to sell or stop buying treasury yields may cause issues in the current market.

It can be hopefully expected that the federal reserve will act accordingly as it has up to this point to uphold its fiscal responsibilities and keep the economy moving properly.

Sources:

(1) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm

(2) https://www.forbes.com/advisor/personal-finance/stimulus-packages-throw-money-at-financial-crises-but-do-they-actually-help-the-economy/

(3) https://www.pwc.com/us/en/library/covid-19/coronavirus-impacts-retail-banking.html

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