By Hu Benton and Hugh Carney
Banks have been a stabilizing force during the economic downturn caused by the global pandemic, acting as safekeepers of deposits, conduits for government relief programs and liquidity providers to their customers. Those positive actions are helping people and businesses weather the pandemic, while maintaining strong bank capital levels, but they are also leading to an unintended negative side effect—declining leverage ratios for banks of all sizes. As a result, healthy banks large and small could be prevented from providing the support that the recovery needs right now. They might even be forced to turn away deposits.
Some rules that keep our system safe under normal circumstances by carefully measuring and offsetting risk have performed well despite the distorting effects of the pandemic economy, while others simply don’t work in the current environment. And banks—small and big alike—are struggling to absorb an unprecedented flood of deposits as the federal government has approved multiple rounds of economic stimulus totaling more than $5.3 trillion. Whether the funds have gone to individuals, businesses, or state and local governments, that stimulus has landed in bank accounts. Under normal circumstances, deposits are the lifeblood of bank lending, but nothing is normal right now.
Despite this unprecedented deposit surge, risk-based capital ratios, which calibrate capital to the likelihood an obligor will default, have remained strong as banks have invested deposits in safer assets such as Treasuries; but leverage ratios, which measure capital relative to all assets regardless of risk, are on the decline due to the unusual economic conditions caused by COVID-19. To illustrate, the largest banks are required to hold 5 percent capital against all assets, including the safest of the safe. In times like now, where we have seen a “flight to safety” from depositors, this leverage ratio has become what’s known as a binding constraint, instead of a safety net. Aware that some of the existing rules might restrict banks from using their balance sheets to support the economy during the pandemic, last spring bank regulators temporarily eased the supplementary leverage ratio, or SLR, for large banks and the community bank leverage ratio, or CBLR, for smaller banks.
That sensible relief is coming to an end, however, just when another $1.9 trillion is flowing into the economy. Federal regulators announced last week they will let the temporary SLR changes expire March 31, and the CBLR relief is already being phased out and is set to expire at the end of this year. As that temporary relief begins to sunset, it is worthwhile to consider whether inflexible bank leverage ratios are doing more harm than good to an economy facing an uncertain recovery.
Starting in March 2020, when stay-at-home orders put the economy into a partial state of suspended animation, consumers and corporations alike sought the safety of the banking system: Congress’ massive fiscal stimulus package sent a flood of direct payments into consumer and small business bank accounts; businesses shored up their own liquidity by drawing down credit lines; and savings balances grew as consumers reduced their spending. All told, more than $3.3 trillion in deposits flowed onto bank balance sheets in 2020, with increases averaging between 21 percent and 27 percent. While each institution’s experience has been unique, the flood of deposits has affected banks of all sizes.
When investing deposits in liquid and safe assets—for example, buying Treasury securities—a bank’s risk-based capital ratio remains steady because the assets receive a zero percent risk weight. During the past year, bank risk-based capital levels reached new heights, rising 1.33 percentage points.
Yet even though the industry’s risk-based capital levels have been increasing, as deposits have surged, Tier 1 leverage ratios—which compare the amount of capital to the size of assets—have been declining. Investments in Treasury and agency securities and central bank deposits actually reduce a bank’s leverage ratio, because all assets are treated the same, regardless of their risk profile. Super-safe assets are counted just the same as other assets—and banks are expected to hold a capital buffer against them, even when there is essentially no risk of loss.
Which brings us to today. We are learning that leverage ratios can create a disincentive for banks to accept deposits during a crisis. This is why regulators provided temporary leverage-ratio relief at the onset of the pandemic, and why politics should not cloud prospects for an extension until federal stimulus exits the system.
It’s especially disappointing that declines in Tier 1 leverage ratios have been most pronounced for banks that have gone the extra mile to ensure their customers have access to funds, including through federal programs like PPP. Unfortunately, one well-intentioned program that was designed to avoid penalizing banks participating in PPP was poorly calibrated. Banks that pledged their PPP loans—which were fully guaranteed by the Small Business Administration—to the Federal Reserve’s Paycheck Protection Program Liquidity Facility were allowed to exclude those loans from both their leverage ratio and risk-based capital calculations. The interest rates offered by that facility, however, led most banks to conclude that it was not cost effective, so they declined to participate in the PPPLF. The market spoke loudly, with less than 10% of PPP loans by volume excluded from leverage ratios.
While it is appropriate for regulations to be written for normal economic circumstances, it is also appropriate to extend regulatory flexibility during times of crisis. At this historic moment, it is worth considering the unintended consequences of leverage ratios—for banks of all sizes. Policymakers should not penalize banks for stepping up and taking deposits—a core banking function—while consumers, businesses and governments value safety over yield. Even Federal Reserve Chairman Jerome Powell acknowledged the unintended consequences when he testified at a March 23 House hearing and told lawmakers, “Because of the substantial increase in reserves and treasuries, the leverage ratio has rapidly becoming the binding constraint from a capital standpoint and that wasn’t our intention at the Fed from the beginning. We like risk-based capital to be binding because it forces banks to manage their risks more carefully.”
Instead, the banking agencies should evaluate how regulations are applied in national emergencies and other stress environments. Initially, they were responsive, providing temporary flexibility related to asset thresholds, deposit insurance assessments, the CBLR and the SLR. But in declining to provide an extension for SLR flexibility beyond March 31, regulators will force some large banks to make balance sheet changes that could run counter to the needs of the recovery and put more pressure on an already-saturated banking system. Community banks will be left to absorb the runoff, yet they themselves will face similar challenges under the CBLR unless regulators extend that temporary flexibility. Time is of the essence to address the CBLR, especially as large banks make hard choices in anticipation of March 31.
To its credit, the Fed has indicated it will seek public comment “relatively soon” on recalibrating the SLR going forward to reflect the experience of the past year. As it does so, it would be prudent for bank regulators to consider this key question: Should leverage ratios (SLR, Tier 1, and CBLR) exclude safe assets that have grown on bank balance sheets simply as a result of banks serving their traditional role as a haven during financial stress? For anyone interested in seeing banks large and small continue to support the recovery, the answer should be yes.
Hu Benton is VP for banking policy at ABA. Hugh Carney is SVP for prudential regulation at ABA.
ABA Viewpoint is the source for analysis, commentary and perspective from the American Bankers Association on the policy issues shaping banking today and into the future. Click here to view all posts in this series.