For those who doubt the impact of regulation on market behavior, one need look no further than the repo market. Here, through happenstance, a key difference in how the leverage ratio is applied in the United States versus Europe allows us to see just how powerfully regulation can affect market behavior.
Quick background: a leverage ratio is a measure of a bank’s capitalization that is, at least in principle, calculated as the ratio of equity to assets with no risk-weighting of the assets. As part of the Basel post-crisis international regulations, all internationally active banks are subject to the supplementary leverage ratio (SLR). The Basel standard is a SLR of 3 percent, but the United States bank regulators adopted an “enhanced” supplementary leverage ratio (eSLR) of 6 percent for the largest commercial banks and 5 percent for their bank holding companies.
Most importantly, for the present analysis, note that the SLR in the United States is measured as an average of daily values while, in Europe, the SLR is measured only at quarter end.
One day out of each quarter, hundreds of billions of dollars flood into the Federal Reserve from money market funds (the gold line in the chart). The money market funds are looking for a place to invest because on those days, the European banks (the blue line in the chart) that they usually lend to temporarily stop borrowing. The money funds, which have to invest their customers’ funds somewhere, instead put their money in the Fed’s overnight reverse repurchase (ON RRP) facility even though it provides a below-market rate of return. Moreover, as shown by Munyan (2015), in an OFR working paper, financial market liquidity declines at the end of each quarter as a result.
The European banks stop borrowing, and simultaneously reduce their reverse repos and deposits at the Fed funded by that borrowing, because their regulatory leverage ratios are measured on that day, and their leverage ratios are stronger if the banks make themselves smaller. A recent New York Fed blog post (from which the chart above is copied) provides a more complete discussion of these flows, their regulatory drivers, and their impact on financial markets.
The other 89 days of the quarter, European banks face no leverage ratio requirement while the largest U.S. banks must meet a requirement that is twice the international standard. Not surprisingly, as discussed in a recent FT article, and shown in the graph below, as money market mutual fund demand for repos against Treasury securities has risen sharply over the past year and a half because of money fund reform, the increased demand has been met by foreign, not U.S. banks. More generally, if you require U.S. banks to fund low-risk activities with expensive capital, they will respond by cutting back on those low-risk activities, and shifting instead to higher-risk activities instead where the playing field is more level.
In sum, the leverage ratio, and a de facto exception to that ratio for European banks, has (1) significantly altered the competitive balance in the repo market to the disadvantage of US banks; and (2) forced the Fed to take on a new role of borrower of last resort – and to serve that function on a quarterly basis.
We have done previous research to document numerous problems with the leverage ratio as a conceptual matter. In one note, we demonstrated that during the financial crisis, the leverage ratio was a very poor (even contrary) measure of the likelihood of failure. In two other notes, we demonstrated its impact on monetary policy: how the costs of the leverage ratio will constrain the Federal Reserve’s choice of monetary policy framework and put downward pressure on the equilibrium federal funds rate, making monetary policy less effective and increasing the likelihood of hitting the zero lower bound in the future.
But, as the experience with the repo market shows, its most direct effect is to drive many U.S. banks away from low-risk assets, like reverse repos against Treasury securities, where narrow margins are incompatible with a 5-6% capital charge.
Despite its shortcomings, a leverage ratio requirement could serve as a sensible backstop to risk-weighted capital requirements to guard against the possibility that regulators underappreciate the risk of one type or another of bank assets. But even to function in that capacity, the leverage ratio requirement needs to be calibrated to be a backstop. Indeed, when approving the SLR, each member of the Board of Governors indicated that they were only comfortable doing so because they thought the SLR was or soon would be a backstop to risk-weighted requirements. Unfortunately, as reported in a recent TCH working paper, the leverage ratio requirement included in the Board’s annual stress tests is now the capital requirement that is closest to binding for about half of the large banks in the United States. In addition, as shown by Greenwood, Hanson, Stein and Sunderam (2017), the SLR requirement included for the first time in the latest round of stress tests is the post-stress requirement more likely to bind for 6 out of 8 U.S. GSIBs.
The intra-quarter swings in repo activity demonstrate that the leverage ratio is binding for many banks and affecting U.S. competitiveness. We see a range of problems for financial stability caused by penalizing U.S. banks for holding low-risk and high-liquidity assets. In normal times, U.S. banks lose business and the repo market loses some liquidity. If stress occurs, we had best hope it does not come at quarter end, or at European banks on which the repo market now depends. And if a central goal of post-crisis capital rules was to prevent the Fed from having to intervene and support markets in the next financial crisis, it cannot be ideal that one of those rules is now requiring the Fed to intervene on a quarterly basis.
