Last week on 26th June, the Federal Reserve announced proposed changes to the supplementary leverage ratio (SLR) calculations. The changes would primarily impact the global systemically important banks (GSIBs) that are subject to enhanced supplementary leverage ratio (eSLR) requirements. Currently, the requirement is calculated as the sum of a baseline 3% plus a leverage buffer of 2% (the requirement for the insured depository subsidiary is 4%+2%). The proposal would modify the calculation of the buffer to equal 50% of the bank holding company’s Method 1 GSIB surcharge rather than a fixed 2%. Also, in contrast to what was widely expected in the market, there would be no exclusion for Treasuries. However, they have requested market input on whether Treasuries held for trading and Treasuries held at broker-dealer subsidiaries should be excluded from the denominator of the SLR calculations. From a credit perspective, the bullish thesis remains intact, long-term debt needs decline which should help technically and while capital requirements were reduced, SLR was not a binding constraint for most banks so overall CET1 levels should remain stable. Banks have already started to react to this less restrictive outlook for capital, with stock repurchases increasing and CET1 ratios declining from their peak in 4Q24. The optics of providing SLR relief while banks are simultaneously reducing their capital may make it seem like the former is causing the latter. But that is not true, even if they were to happen concurrently. The currently proposed eSLR relief should move the leverage constraint out significantly, to an extent that is unlikely to be binding under most conceivable scenarios. But this will make sense only as long as it is profitable to do so - in other words, adding Treasuries or repo to the asset side needs to be met by liabilities that are cheap enough for this activity to be profitable. The invitation to comment on a potential exclusion for Treasury securities held on the trading books, if approved, would have significant effects. It would mean that market risk would be the main constraint for banks' decision to hold Treasuries, and encourage more hedged positions in Treasuries, such as in swap spreads. Banks could also make more repo available to their leveraged fund clients with the additional balance sheet capacity in the current proposal. We believe that the front-to-belly spreads offer the highest risk-adjusted carry profile. However, if investors lower their threshold for risk there is more widening potential further out the curve. Investors who are buying spreads for a larger increase in risk-bearing capacity, rather than just leverage, should therefore target longer-tenor spreads.
