Did The Fed Just Send A Message?

In case you missed it, last Friday, the Federal Reserve agreed to let a year-long suspension of capital requirements for big banks that allowed them to exclude Treasury securities and deposits held at the Fed from their supplementary leverage ratio expire at the end of the month.

While the subject of bank capital ratios usually puts some people to sleep, the Fed decision could have very real consequences for the financial markets and the nascent economic rebound at large. It also seems to diverge from the Fed’s own stated and oft-repeated monetary policies.

Then again, the Fed may have just sent a subtle message that its low-rate stance is about to change.

As the New York Times explained, the intention of relaxing the banks’ capital requirements last year at the outset of the pandemic-induced economic lockdown “was to make it easier for financial institutions to absorb government bonds and reserves and still continue lending. Otherwise, banks might have stopped such activities to avoid increasing their assets and hitting the leverage cap, which would mean raising capital. But it also lowered bank capital requirements, which drew criticism.”

At a practical level, Friday’s decision may add further fuel to the fire that is driving up bond yields by discouraging banks from buying Treasury securities, which would seem to run counter to the Fed’s low-interest-rate policy. The Fed, of course, is buying trillions of dollars of Treasury and mortgage-backed securities, which it has stated it has no intention of stopping. Yet, it saw fit to make a move that could have the effect of driving the banks – also big buyers of government securities – out of the market. So why did the Fed do this?

On one side of the debate over the SLR extension were the banks, who argued that the reimposition of tougher capital requirements might lead them to pull back on Treasury bond purchases, which could raise interest rates, but also “hamper their ability to extend credit to companies and consumers, and in some cases force them to turn away deposits,” the Financial Times said.

“With reserves expected to keep growing rapidly, banks might end up having to limit their activity in some financial markets or even lend less,” the Wall Street Journal’s Greg Ip wrote. “This outcome would obviously run counter to the Fed’s monetary policy goals of keeping interest rates low and credit flowing to get the economy back to full employment.”

Moreover, he added, “With that capital requirement back in place, the Fed achieves nothing toward making the financial system safer while potentially raising headwinds to its other goal: stoking an economic recovery with easy credit conditions.”

On the other side—which proved to be the winning one—were liberal Democrats in Congress, who decried the idea of extending relaxed capital requirements for banks even as they’ve resumed stock buybacks and dividend payments to their shareholders.

“The banks’ requests for an extension of this relief appear to be an attempt to use the pandemic as an excuse to weaken one of the most important post-crisis regulatory reforms,” Sen. Sherrod Brown, the chairman of the Senate Banking Committee, and the banking industry’s long-time nemesis, Sen. Elizabeth Warren, wrote last month in a letter to bank regulators, including Fed Chair Jerome Powell. “To the extent there are concerns about banks’ ability to accept customer deposits and absorb reserves due to leverage requirements, regulators should suspend bank capital distributions.” In other words, if you want capital relief, you can’t pay dividends, too.

In its decision not to extend the relaxed SLR requirements, the Fed did say that it would seek a permanent fix to the issue.

After resuming dividend payments and buybacks – with the Fed’s approval – reporting strong earnings and starting to release bad-debt reserves, the banks’ argument that they still need capital relief does seem a bit of a stretch. The fact is that the economic impact of the pandemic – thankfully – has not been as severe as most experts forecast. The banks had a couple of tough – but hardly disastrous – quarters but then quickly rebounded. But that’s almost beside the point.

The fact remains that the Fed continues to base its monetary policy on a disaster scenario that has not materialized – which the Fed and the government stimulus measures should rightfully take a victory lap for – and it reiterated at this month’s meeting that that policy will remain in effect for another two years. Yet, at the same time, it saw fit to end the easing of a capital requirement for banks that is part of that policy. Following its own logic, the Fed should have extended the suspension, yet it took the opposite tack.

Or was it the Fed’s way of sending a signal that it’s okay with higher rates? Stay tuned.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.