The Flip Side podcast – Episode 75

Brad:
Welcome to another episode of the Flip Side. I am Brad Rogoff, global head of Research. And joining me is Jason Goldberg, our U.S. Large-Cap Bank Analyst in equity research, just ahead of Barclays’ 23rd annual Global Financial Services Conference.

Jason, thanks for joining us. You must be very busy.

Jason:
Thanks for having me, Brad. We have a dynamite speaker line up including senior financial regulators, plus over 200 global financial services companies and nearly one thousand institutional investors attending our annual conference. It is certainly super timely and should be informative as investors get to hear directly from key industry players.

Brad:
This is the first time you will have all those companies in one place following the new administration in Washington. Regulators have been quick to propose changes that have for the most part been cheered by bank investors. What I want to spend time on today is just how important these changes are and whether they will be the panacea that some think. Let’s focus on one that has gotten a lot of fanfare: bank capital, including recently proposed changes to the supplementary leverage ratio, or SLR, at the largest banks.

II. SLR & Proposal Explained

Jason:
Definitely one that is going to come up a lot at the conference. Born out of the global financial crisis, SLR is a regulatory standard that was initially developed by an international organization, the Basel Committee on Banking Supervision in 2011 and implemented in the U.S. by the bank regulators in 2014. It measures a bank’s Tier 1 Capital, which is mostly common equity, relative to its total leverage, which is primarily total assets plus certain off-balance sheet exposures. A leverage ratio acts as a backstop to risk-based measurements and requires banks to hold a specified amount of capital against their total assets, regardless of the risk of those assets. For banks with over 100 billion dollars in assets, the SLR must be at least 3%. However, as things currently stand the eight U.S. global systemically important banks, or GSIBs, essentially the country’s largest and most global players, are subjected to the enhanced SLR, or ‘eSLR’, which effectively adds a 200-basis point buffer, requiring their SLR to be at least 5%.

Brad:
What caught my eye was a proposal that banking regulators, led by the Federal Reserve, published in late June would change this requirement to 3% plus half of the GSIB’s method 1 surcharge. This surcharge is based on a framework also developed by the Basel Committee and incorporates several categories measuring systemic importance. This would effectively reduce the minimum requirement to between 3.50% and 4.25%, based on the bank’s current surcharge calculation, down from 5% currently.

Jason:
The changes the Fed proposed were a significant reduction to the minimum eSLR requirement, but I would note it chose not to exclude holdings of Treasury securities and deposits at Federal Reserve Banks from the leverage calculation, something it temporarily did in 2020 during the onset of the COVID-19 pandemic. Still, it did invite comments on a potential additional modification that would exclude from the denominator held-for-trading Treasury securities of certain broker-dealer subsidiaries. Also of note, the vote was 5 to 2 on the proposal as a couple of Fed Governors did in fact dissent.

III. Safety & Soundness

Brad:
And let me tell you Jason, I do share some of their concerns. Lowering the SLR requirement will reduce the capital buffer that the largest banks hold against their total exposures, including off-balance sheet items. Off-balance sheet exposures can obscure leverage, and they were partially responsible for the failure of some institutions during the 2008 global financial crisis. With thinner equity cushions, banks may be more vulnerable in times of stress, as they would have less loss-absorbing capital to protect depositors, creditors, and the broader financial system.

Jason:
I’d counter that Brad, by noting banks are already subjected to multiple overlapping capital and liquidity requirements, like the CET1 ratio where risk-weighted assets are in the denominator, in addition to the GSIB surcharge and stress testing. As a result, the SLR minimum does not meaningfully alter their resilience. All the large banks already maintain capital levels well above the leverage ratio floor, implying the proposed change should have little effect on actual balance sheet strength. In fact, banks will likely continue to manage investor expectations, rating agency thresholds, and internal risk appetites, all which demand capital above regulatory minimums.

Brad:
So are you saying we shouldn’t have the SLR at all?

Jason:
I don’t know if I would go that far, but let’s remember why the SLR was introduced. After 2008, regulators wanted multiple lines of defense. Risk-weighted capital ratios could still be managed, so the SLR was viewed as a belt-and-suspenders approach. But we must acknowledge that the financial system has changed. The Federal Reserve’s balance sheet ballooned after COVID, flooding banks with deposits and reserves. That artificially inflated the denominator of the SLR. Banks looked overleveraged on paper, even though the assets were very safe.

Brad:
But that is the point, Jason. The SLR was supposed to capture all exposures, not just risky ones. Yes, reserves and Treasuries take up space, but they’re still assets. If you start saying some assets are less concerning, you undermine the core principle. Remember, in 2008, people thought AAA-rated securities were safe. They weren’t necessarily. Regulators should be cautious about lowering minimums just because banks say they’re uncomfortable.

In part it feels like this is a reaction to what happened in March 2020 when the Treasury market became dislocated, and dealers faced difficulties absorbing large volumes of Treasuries despite their high credit quality. Does this even do enough?

IV. Treasury Market

Jason:
A lower SLR should improve Treasury market liquidity by making it easier for banks to hold and intermediate large amounts of Treasuries. In recent years, particularly during periods of heavy issuance or market stress, the SLR has been a constraint preventing dealers from expanding their balance sheets to absorb Treasuries, which can amplify volatility and illiquidity. By easing the leverage requirement, banks would have greater incentive to warehouse Treasuries and make markets more efficient, supporting smoother functioning in the world’s benchmark fixed-income market.

Brad:
But the Fed excluded Treasuries from the SLR as we mentioned earlier in 2020 and that didn’t really do the trick.

Jason:
In March 2020, the only way the Fed could unfreeze the market was through massive intervention. The Treasury exemption was one part of a reaction function and since it was not likely to be permanent in nature it was hard to change the reaction function of banks. Permanently lowering the SLR reduces the odds of the need for a large-scale intervention again. If the Treasury market isn’t stable, nothing in global finance is.

Brad:
I gotta tell you Jason, I am skeptical it will achieve the stated objective of improving the resiliency of the Treasury market, especially in times of stress. Banks can easily shift to other activities with low risk-based capital requirements and higher returns than Treasury market intermediation. Moreover, much of the capital that is freed up at the holding company level, where not otherwise constrained, is likely to be diverted to other activities, rather than intermediation. Even if some further Treasury market intermediation were to occur in normal times, this proposal is unlikely to be helpful in times of stress. If banks use up their excess capital in normal times, there will not be excess capital in stressful times. In addition, banks’ internal stress models measuring value at risk will likely limit Treasury intermediation when volatility increases, as they have in the past.

V. Bank Lending

Jason:
Still, lowering the SLR requirement should increase bank balance sheet flexibility, increasing lending capacity. In the current environment, large reserves and Treasuries can crowd out other assets, including loans. A reduction in the minimum requirement frees up capacity for banks to grow their loan portfolios, which could stimulate broader economic growth and benefit mainstream America.

Brad:
I’d counter by noting loan growth is much less driven by regulatory capital constraints and more so by borrower demand and economic conditions. Even if banks have additional capacity from a lower leverage requirement, they will not lend unless there is profitable demand and manageable risk. Moreover, risk-based capital rules remain binding for most loan categories, so the reduction in the SLR minimum requirement should not significantly change the economics of extending credit.

VI. Competitiveness

Jason:
Still, you must admit, having a higher SLR in the U.S. than other countries could put the U.S. banks at a competitive disadvantage. Global banks compete for trading, underwriting, and financing mandates, and higher capital requirements could make U.S. institutions less willing to warehouse assets, underwrite deals, and provide balance-sheet-intensive services at competitive prices. In addition, as you noted so eloquently in episode 73, banks are now competing against non-bank financial intermediaries such as hedge funds, private credit funds, and principal trading firms. These proposed changes put U.S. banks on a more even footing in addition to allowing them to compete more effectively against less or un-regulated entities.

Brad:
I appreciate your attempt to use flattery to try to win this debate. This is a very valid concern you bring up in terms of global competitiveness amongst banks and non-banks. As you alluded to at the beginning of our conversation, most large U.S. banks already operate with capital levels well above their regulatory minimums due to market discipline, stress test requirements, and shareholder expectations. They are still going to want large buffers, so I think a modest adjustment in one ratio is unlikely to significantly change pricing power or competitive positioning.

Jason:
They will keep buffers, but I still believe lowering the SLR minimum is a sensible adjustment. The proposed changes are intended to reduce regulatory disincentives for the banks to engage in lower-risk, lower-return activities. It reflects today’s realities including bigger central bank balance sheets, higher Treasury issuance, and a global system where U.S. banks already carry more capital than their international peers. We need to keep the leverage ratio from being an artificial bottleneck. This change helps banks, helps the Treasury market, and ultimately helps the economy.

Brad:
I understand it helps directionally, but I think we have different views on the scale. Moreover, banking competitiveness is influenced by many other factors—such as technology, client relationships, regulatory clarity, and the depth of capital markets—far more than by a single leverage requirement. As for activity migrating to the so-called shadow banks, non-bank players have carved out niches driven by flexibility and yield rather than regulatory arbitrage alone. Therefore, lowering the SLR may marginally influence competitive dynamics but is unlikely to be a decisive factor in reshaping where financial activity takes place.

VII. Conclusion

Jason:
And this is where we get back to your comments that there is a lot going on in Washington. Having lived through a lot of regulatory regimes, I really believe one needs to look at bank capital reform holistically. What is happening right now could have a much more significant impact in improving the banking industry’s ability to intermediate and finance as well as increasing capital return and the industry’s profitability. We have already seen capital requirements decline post this year’s stress test and the Fed has promised to take actions to reduce the volatility of its results and improve its transparency looking out. In addition, we expect the implementation of the Basel III endgame proposal by U.S. regulators to be much less harsh than initially expected, while the GSIB surcharge applied to the largest banks will likely come down as well. There is still more work to be done this year, and we are hopeful this can be finalized in 2026.

Brad:
Whether it is SLR or any of the other potential changes you mention, my fear is banks will use the freed-up capital for shareholders and trading, not lending. Maybe it’s my background as a credit guy, but I fear it won’t meaningfully boost the economy, but it will leave the system more fragile. Hopefully we don’t have another financial crisis anytime soon though to settle this debate.

With that our time together has come to an end. Thanks for listening to this episode of The Flip Side.

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And, if you’re a client of Barclays Investment Bank, you can read more on bank capital in several recent publications available in Barclays Live,
which we’ve linked to in the show notes.

And if you are really interested in the financial services industry, clients can sign up for Jason’s daily morning publication titled the ‘Bank Brief’, which is now heading into its third decade! I never miss an issue, so make sure to check it out in Barclays Live.

Until next time, see you on the Flip Side.