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The Fed Plans to Let a Bank Capital Rule Expire. Here's Why It's Important.

By Bram Berkowitz - Updated Mar 19, 2021 at 4:32PM

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Bank regulators elected to let an exclusion to the supplementary leverage ratio (SLR) expire on March 31, a headwind for the banking sector and bond market.

Regulators plan to let an exclusion on bank capital rules that was implemented early in the pandemic expire at the end of the month, which could trigger further volatility in the bond market. The rule could hurt some bank stocks as well.

The exclusion had to do with a bank capital requirement related to a metric called the supplementary leverage ratio (SLR). Banks were required to maintain a certain amount of capital for their total balance sheet and off-balance sheet exposure. But when bank balance sheets exploded early in 2020, regulators allowed banks to exclude deposits held at the Federal Reserve and U.S. treasury notes from their total leverage exposure.

Picture of building with the word bank on it.

Image source: Getty Images.

The exclusion was meant to ensure that banks didn't get too close to their SLR regulatory thresholds and weren't impeded from lending during the pandemic. The move also helped calm Treasury markets after a massive sell-off of notes early on in the pandemic.

Without the exclusion in place, some are worried banks may sell some of their Treasury notes, sending long-term bond yields higher, which has been a major headwind for a good chunk of the market.

The one bright spot for banks is that the Fed said it plans to seek comment on measures to adjust the SLR, which banks have long lobbied for.

The SLR is a measure of capital adequacy for all leverage exposure both on and off of a bank's balance sheet. It was implemented following the Great Recession after banks' off-balance-sheet leverage through things like derivatives rocked the global banking system.

The SLR is calculated by dividing a bank's tier 1 capital, such as shareholder equity and retained earnings, by its total leverage exposure, which includes total assets and all off-balance-sheet items such as derivatives. The larger banks must maintain an SLR above 5%.

Many bank executives have argued the SLR is not a great measurement because it is not risk-based.

The main reason banks saw their total leverage exposure surge early in 2020 was due to a flood of deposits into the banking system, which increased assets and therefore leverage exposure. But deposits do not necessarily make banks' balance sheets more risky.

The expiration of the exclusion could hurt some large banks such as JPMorgan Chase (JPM -0.70%). At the end of 2020, JPMorgan had an SLR of 6.9% with the exclusion in place. Without it, the bank would have had an SLR of 5.8%. Not all banks are affected as much -- executives at Bank of America (BAC -1.02%) have said they would not run into any SLR issues if the exclusion runs out.

JPMorgan's CFO, Jennifer Piepszak, said on the bank's last earnings call that if the SLR exclusion runs out, the bank may be forced to consider reducing or turning away deposits, issuing preferred stock, or retaining more common equity than the bank would normally need to.

Shares of JPMorgan were down as much as 4% Friday before finishing the day down 1.6%.

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