The Fed’s decision is a credit positive for investors, and debt and preferred issuance should be manageable for the market.

The Federal Reserve announced on March 19 that it would not extend the temporary Supplementary Leverage Ratio (SLR) exemption past March 31 of this year. As a reminder, on April 1, 2020, the Fed granted banks a temporary exemption that allowed them, subject to the SLR, to exclude on-balance-sheet Treasuries and deposits at the Fed from the denominator of the ratio. By excluding these items, banks easily complied with the SLR. This provided banks with flexibility to accept deposits, lend money and participate in the Treasury market to reduce volatility early in the COVID-19 pandemic.

With the end of the exemption, the SLR at the large banks will fall, but will remain above the minimum requirement. Overall, we view the Fed’s decision as a credit positive for the large U.S. banks, as they will be subject to the strictest SLR requirements. The banks, however, will need to make adjustments to ensure that they maintain sufficient buffers above the SLR requirement. This will most likely mean more preferred issuance to boost the numerator of the ratio. Estimates peg additional net supply in the range of $15 – 20 billion this year, which we view as a manageable amount for the market. Some large banks will also issue senior unsecured debt to maintain buffers over other regulatory requirements. We believe the incremental amount of debt needed should be manageable in the $35 – 40 billion range.

Away from issuing preferred and debt instruments, banks may consider other strategies to manage their balance sheets to comply with regulatory requirements. Strategies may include: (1) modifying capital return plans, (2) reducing deposits, and (3) scaling back businesses that are more impacted by Treasury holdings. The last two points are of particular interest as the banks played an important role in stabilizing the market by accepting deposits, lending money and intermediating in the Treasury market at the start of the pandemic.

The SLR was intended to complement capital requirements and prevent banks from taking on too much leverage. We do not believe bank regulators intended the SLR to become a binding constraint for banks. We also think the Fed is keenly aware that future growth in bank reserves and Treasury securities could undermine financial stability. As such, it is probable that the Fed recalibrates the SLR in the future, providing more balance sheet flexibility, while maintaining the safety and soundness of the U.S. banking system.