The Federal Reserve Board began the second quarter of the year by relaxing part of its capital rules for bank holding companies. In particular, its interim final rule would exclude from some capital calculations the investments that banks have in funds placed with the Fed and holdings of U.S. Treasury securities.


To be more specific, the rule targets the supplemental leverage ratio, which applies to the larger bank holding companies, generally those with more than $250 billion in assets. These firms maintain more than half of the banking assets in the country.


The supplemental leverage ratio is one of more than a dozen ways that banks are required to calculate capital (though regulators in practice rely upon fewer than half that number). It is a risk blind measure that looks at all of the banking firm’s assets, without regard to their risk, and directs that the firms have capital equal to a certain percentage of those assets.


The purpose of bank capital is to have a financial cushion to absorb future losses.  U.S. banking rules embrace two types of capital measures: risk-based capital, which is calculated in accordance with the riskiness of assets; and risk-blind, or leverage capital, which, as mentioned above, calculates capital by the total amount of assets, regardless of risk. The first offsets the blindness of the latter, and the latter compensates for limitations of risk measurement and risks that are unexpected or cannot be adequately measured.   


The interim final rule rests upon the recognition that you really do not need capital to absorb losses where the risk of loss is pretty close to nil. Quoting from the Fed’s discussion, “As Treasuries and deposits at Federal Reserve banks are free of credit risk, their exclusion will also not incentivize risk-taking by banking organizations.” Out of its abundance of caution the Fed promises, “The Board will closely monitor the balance sheets of banking organizations subject to the interim final rule in the coming months with a particular view toward any resulting increase in risks.”


There has long been concern that requiring banks to hold capital against their Fed reserves would penalize them for accommodating the usual influx of customer deposits in times of economic distress. In those seasons, money surges into banks from investors seeking safe havens.  Banks are shy of using these deposits to fund loans, since the tide of these deposits can just as quickly ebb, leaving loans unfunded. As a recourse, banks generally invest this deposit surge in Treasurys and reserves at the Fed, which can be quickly liquidated to refund subsequent customer withdrawals. While holding these deposits, however, usual leverage ratio rules require banks to have capital for the assets in which they are placed. The logic of the interim final rule is to end this penalty and allow bank capital to be more available for lending and for supporting financial market liquidity.      


As an interim final rule, this change is effective immediately. It is scheduled to remain in effect through March 31, 2021. It is also open to public comment (the comment period is 45 days from when the rule is published in the Federal Register), which comments could conceivably convince the Fed to make changes to the rule.