With the economic recovery still in its early stages, an important component of the Federal Reserve’s response to the economic collapse last spring is in danger of expiring.
Lowering the supplemental leverage ratio helped bring stability to the banking sector in a time of distress.
It’s called the supplemental leverage ratio, or SLR, and the Fed lowered it last spring to help banks maintain liquidity and continue lending through the deepening crisis. In the end, it helped bring stability to the banking sector in a time of distress.
But that more accommodative policy on the leverage ratio will end on March 31 unless the Fed takes action. If it does expire, lending to small and medium size enterprises could slow just as the U.S. economy is emerging from a deep recession. The impact of a reduction in lending could reverberate across financial markets and ultimately slow down the economic recovery.
Lowering the SLR was just one of many aggressive actions the Fed took last spring to stabilize the economy as uncertainty about the coronavirus spread across the U.S.
The Fed’s intent in reducing the ratio was to allow the nation’s largest banks to build liquidity on their balance sheets by taking on customer deposits, which could then be used to purchase Treasury securities or be kept in reserves at the Fed. This could be done without requiring these institutions to hold more in capital to safeguard against losses.
That added liquidity could then be deployed into the economy through lending to struggling businesses and consumers. Some of this lending was done through programs like the Paycheck Protection Program. That liquidity was also intended to spur more lending as the economy recovered.
The policy has worked as intended: Since the SLR was lowered last March, liquidity has ballooned at the nation’s banks. The reserves at the nation’s eight largest banks more than doubled to nearly $1.2 trillion, according to data compiled by Bloomberg. This is in addition to the hundreds of billions of dollars in Treasury securities that institutions bought at the same time.
With the economy on the verge of what could be the most robust period of growth since the 1980s, a reversal of the lowered SLR could threaten this growth. The impact could show up in two ways:
- Interest rates: With no further SLR accommodation, it’s reasonable to expect that banks benefiting the most would shrink their balance sheets through flooding the financial markets with the reserves they no longer need or want. The consequence would be twofold, placing significant pressure on short-term rates – overnight and repo – as well as in the broader Treasury market. This would likely introduce significant rate volatility in the market for Treasury securities and could ultimately push the already low short-term rates lower, possibly even negative.
- Economic recovery: Institutions countering the reversion of the SLR to avoid holding more in capital through shedding their excess liquidity will constrain financial conditions as a result of tightening lending standards. Without the ability to carry more liquidity on their books, lending institutions will be faced with onerous decisions on whom to extend credit to – meaning some businesses that may have received loans previously will not. This would come as businesses are beginning to see the light at the end of the pandemic tunnel and looking to ramp up operations. As this happens and cash is deployed, the need for borrowing increases.
The clock is ticking
At a time of rising growth expectations, increasing interest rates and modestly higher inflation expectations, addressing the SLR will become a likely regulatory policy imperative for the Fed in the coming weeks.
While we don’t expect the Fed to simply let the SLR accommodation expire, which would introduce unintended risk to interest rates and the velocity of the economic recovery, we do anticipate that a modest extension will be granted to keep the wheels on the economic recovery moving.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.