For years, the country’s biggest banks lobbied against a post-2008 financial crisis rule that was intended to shore up their stability and ensure they could withstand steep losses in times of turmoil.
This week, financial regulators led by the Federal Reserve agreed to ease the rule, embarking on what is expected to be an extensive push to loosen the regulatory reins on Wall Street.
The rule in question, the supplementary leverage ratio, mandates that lenders maintain a buffer of easy-to-access money against their total leverage. That measure includes assets such as loans and Treasuries as well as exposures that do not appear on a bank’s balance sheet but generate income, like derivatives.
It is not the first time that the Fed has given the banks a big break on this front. As financial markets melted down at the onset of the Covid-19 pandemic, the Fed offered a temporary reprieve so that banks had more leeway to lend to businesses while staying active in the all-important U.S. government bond market at a time when the economy was reeling from a big shock.
But in loosening the rule in a permanent way, which the Fed voted 5 to 2 in favor of doing on Wednesday, opponents warn that it risks making the financial system more fragile at a time when President Trump’s policies are stoking extreme volatility.
“You lower capital requirements, you build up leverage in this system, which by definition, is going to create less resilience,” said Sheila Bair, who served as chair of the Federal Deposit Insurance Corporation between 2006 and 2011. “You should have a really good reason to do it, and I don’t see the reason.”
The proposal advanced by financial regulators this week would reduce the capital buffer for the eight biggest banks, which are considered the most systemically important given their size and ties to the overall financial system.
Those institutions, whose teetering would wreak havoc across the global economy, have been required since 2014 to maintain what was known as an enhanced supplementary leverage ratio of at least 5 percent of their total assets.
The change would reduce that ratio to a range of 3.5 percent to 4.5 percent, translating to a reduction in capital requirements of $13 billion, or 1.4 percent at the holding company level.
Jerome H. Powell, the Fed chair, voted in favor for the proposal, saying it was “prudent” for the central bank to reconsider the earlier rule and ensure that banks are not disincentivized to participate in “low-risk activities.”
The move was immediately cheered by bank lobbyists, who have campaigned for years for regulators to relax the rule.
Greg Baer, the chief executive of the Bank Policy Institute, said the Fed’s proposal was a “first step toward a more rational capital framework.” Kevin Fromer, the president of the Financial Services Forum, said such changes would enable America’s biggest banks to be “better able to support market functions that impact Main Street businesses and consumers across the country.”
Two Fed officials opposed the changes. Adriana Kugler, a governor, joined Michael Barr, who previously served as the vice-chair for supervision before stepping down in January, in voting against the proposal.
Mr. Barr warned that the proposal would increase the risk of bank failures by “unnecessarily and significantly” reducing the size of the safety net. For subsidiaries of the biggest banks, their capital requirements would fall 27 percent, leading to a $210 billion drop in capital.
He and other critics have also warned that the rule change would not dramatically change banks’ willingness to step into the Treasury market and continue financing the government’s ballooning debt.
“This proposal puts our banking system at risk by weakening capital of the largest banking organizations,” Mr. Barr said during Wednesday’s Board of Governors meeting.
A Binding Constraint?
At the crux of the issue is how much the supplementary leverage ratio is restraining banks’ ability to operate. The rule treats traditionally safe assets like Treasuries the same as junk bonds. If banks are on the verge of not having enough capital on hand based on their assets, they cannot make payouts to shareholders or give executives optional bonuses. To avoid breaching that threshold, the risk is that banks stop taking in deposits, making loans or buying Treasuries, all of which are counted as assets.
During the pandemic, banks were allowed to exclude their holdings of Treasuries and cash held at the Fed — otherwise known as reserves — when calculating the ratio. That was to avoid the supplementary leverage ratio becoming what is commonly referred to as a “binding constraint” and dissuading banks from owning government bonds.
Those in support of the Fed’s proposed changes argue that banks will be able to hold more Treasuries, alleviating the pressure on one of the most important markets in the world. That increase in demand from freeing up banks’ balance sheets could push the price of Treasuries higher, lowering yields and, ultimately, the government’s borrowing costs.
Treasury Secretary Scott Bessent, who has made lower interest rates a primary goal, has said that easing the leverage ratio could lead to the yield on 10-year government bonds falling “tens of basis points.” The 10-year Treasury yield influences the rate on mortgages, credit cards and other loans.
However, most large banks are not currently constrained by the leverage ratio, according to analysts at Morgan Stanley. By meeting other capital rules, most banks are already compliant with the leverage ratio, they say. As such, Morgan Stanley analysts do not expect banks to “significantly increase” their Treasury holdings.
Strategists at Bank of America came to the same conclusion. And data from when the leverage ratio was relaxed in 2020 fails to show a clear response from dealers increasing their Treasury holdings, in part because of other forces at play at the time.
Senator Elizabeth Warren, Democrat of Massachusetts, warned in an interview that banks were instead more likely to take measures to boost profits.
“The data show that whenever the regulations are loosened up, the banks turn around and pump that money into dividends and share buybacks,” she said.
“The number one threat to the Treasury market right now is Donald Trump,” she said. “If he and Secretary Bessent were genuinely interested in improving the function and efficiency of the Treasury market, they would first abandon the reckless economic policies stoking bond market concerns.”
“The last thing the Fed should be doing is weakening a rule that would cushion an economic blow,” added Ms. Warren.
Treasury Market set to Swell
The debate comes at crucial moment for the Treasury market. Demand for government debt appears to be waning just as the supply of bonds is set to swell in order to finance Mr. Trump’s tax cut and spending bill, among other things.
With the government borrowing increasingly large sums through the Treasury market, banks have been forced to facilitate trading in a much bigger market but with less room to maneuver because of capital requirements.
Today, banks are responsible for facilitating trading in nearly $30 trillion worth of Treasury securities. At the end of 2008 that number was less than $6 trillion. By 2014, when the leverage ratio was introduced, there was still fewer than half the number of Treasuries outstanding as there are today.
The overarching concern is that faced with a bout of turmoil the market is simply too big for the banks to be able to maintain smooth trading conditions, leading to sharp, disjointed price moves and sparking panic across financial markets.
The Fed did leave open the possibility that it may consider exempting Treasuries held by bank broker dealers, asking for feedback from the public as part of a broader 60-day comment period.
A broker dealer is a specific type of legal entity through which most banks in the United States run their Treasury trading. This tweak would allow banks to build up large Treasury positions during bouts of market turmoil without running foul of the leverage ratio.
“It lets the shock absorber absorb more shock,” said Michael Schumacher, the head of macro strategy at Wells Fargo Securities.
Nellie Liang, who served as undersecretary of the Treasury for domestic finance during the Biden administration, said exempting Treasuries more broadly would be problematic because of the risk posed by rapid fluctuations in interest rates that can cause losses to quickly mount. Also, it could be a “slippery slope,” potentially leading to banks calling for more carve outs, she warned, even as she endorsed the Fed’s decision to reduce the capital buffer overall.
More Regulatory Easing Ahead
Michelle Bowman, who was confirmed as vice-chair for supervision this month, is likely to usher in many more changes beyond the Fed’s newest proposal.
First nominated by Mr. Trump in his first term to be a governor at the central bank and now elevated to be Wall Street’s top cop, Ms. Bowman has already laid out sweeping plans to ease a number of other rules on how banks will be supervised and regulated.
That most likely includes more adjustments to capital requirements and changes to the stress tests that the Fed imposes on the banks to gauge their ability to withstand crises, making them more transparent and predictable. Ms. Bowman has also talked about changing how the Fed rates banks, by downplaying more subjective assessments on an institution’s health.
“Our goal should not be to prevent banks from failing or even eliminate the risk that they will,” she said in her first speech in the new role. “Our goal should be to make banks safe to fail, meaning that they can be allowed to fail without threatening to destabilize the rest of the banking system.”
Lauren Hirsch contributed reporting.
Colby Smith covers the Federal Reserve and the U.S. economy for The Times.
Joe Rennison writes about financial markets, a beat that ranges from chronicling the vagaries of the stock market to explaining the often-inscrutable trading decisions of Wall Street insiders.
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