The Single Fed Mandate & Bank Stocks

May 14, 2025 | Updated | Why did the Fed under Chair Janet Yellen and other bank regulators adopt the Supplementary Leverage Ratio (SLR) a decade ago?  Nobody seems to actually remember what specifically drove the rule other than Washington's simplistic fixation with "capital." But not all risk is a function of capital, even if that is how we measure the cost.

The Federal Register notice is largely silent as to why banks needed extra capital in 2014, when many bank balance sheets were actually running off. “The leverage buffer functions like the capital conservation buffer for the risk-based capital ratios in the 2013 revised capital rule,” the Federal Register states.

The SLR applies to all asset types — treating US Treasuries, reserves, and loans equally, in theory to limit bank on and off-balance sheet exposures from growing too large and thus creating systemic risk. For US global systemically important banks (GSIBs), the minimum SLR requirement is 5%, meaning they must hold an additional 5% of common equity capital above the simple leverage ratio in Basel.  This means that the GSIB must hold more than 10% capital total assets. Is this really necessary? The markets say no.

A number of readers of The IRA have asked whether the Trump Administration should push the Fed to change the treatment for Treasury securities under the SLR. Francisco Covas, Sarah Flowers and Brett Waxman of Bank Policy Institute wrote last July:

“In April 2020, the Fed temporarily removed reserves and U.S. Treasuries from the denominator of the SLR calculation for banks. This was done in response to the Fed’s massive purchases of U.S. Treasury securities in response to the market dysfunction caused by the COVID-19 pandemic. By removing cash and Treasuries from the SLR denominator, the Fed effectively lowered the amount of capital banks needed to hold against these assets, freeing up their balance sheets to support the Treasury market and the economy during the crisis. After the expiration of the temporary SLR relief in March 2021, the Fed stated that it would soon invite comments on several potential modifications to the SLR. However, more than three years later, no public consultation has been launched.”

In theory, the SLR is a binding capital requirement intended to limit “excessive” balance sheet expansion among large banking institutions. It was introduced as part of the Basel III post-crisis regulatory reforms and implemented in the US a decade ago. Since 2014, the growth in the federal debt and the equal inflation of the US banking system through reckless actions such as quantitative easing (QE) have made the SLR seem ridiculous. Eventually the Fed will simply drop Treasury collateral out the the SLR equation permanently because of the size of the federal debt.

Bank balance sheets have grown by 100% over the past 16 years due to the growth of the federal debt and Fed efforts to defend the Treasury market. In 2012, when the Fed formally adopted the 2% inflation target, that was a polite way of telling the financial markets that the dual mandate was kaput. But naturally nobody in Washington noticed. The increase in US bank assets and deposits represent the sort of bloat seen in an unhealthy patient who is taking prednisone to combat inflammation.

Think of the $37 trillion in federal debt as a form of acute disease that is destroying the US economy and private banks. Not only has “excessive” leverage in US banks become a near-impossibility given their grotesque size, but the larger banks led by JPMorgan (JPM) are busily seeking ways to return more unneeded capital to shareholders.

There simply is not enough real demand for credit, outside of the insatiable needs of the US Treasury of course, to justify the current size of the US banking system. Net, net for the banking industry, asset returns are lower as a result. The chart below shows the impact of larger balance sheets on interest income, but note that net interest income is flat even though interest rates have risen 500bp from COVID.

Source: FDIC

Since 2008, the whole political narrative in Washington around banking regulation has been obsessively focused on credit risk. This is called fighting the last war, like the Maginot Line in France prior to the Nazi blitzkrieg in WWII. Credit is the main focus of the Basel Accord going back to the 1980s. The default of less-developed countries (LDCs) is what drove the ministerial agreement known as the Basel Accord, an agreement never ratified by the US Senate or recognized in US law, but notably approved by former Fed Chairman Paul Volcker. 

The big problem with Basel III is that the chief risk to banks today is not private credit risk, which remains quite muted despite almost daily predictions of the apocalypse in terms of an impending consumer recession. Instead, as Silicon Valley Bank illustrated in 2023, the chief risk to US banks and nonbanks alike is market volatility and attendant capital risk. The higher ST risk caused by the increasingly violent ebb and flow of the US Treasury market and the reaction by the Federal Reserve Board in response, may soon swamp even large banks and funds. As you can see below, the net loss rate on all bank loans and leases is still sub-1%.

Source: FDIC

When banks and their lobbyists in Washington argue that the SLR should be reduced to allow banks to hold more Treasury debt, the industry is deliberately missing the point. Large banks want the SLR reduced so that they can increase share buybacks and thereby boost stock prices and related executive compensation schemes. Banks definitely have overmuch capital vs total assets, but any change in basic capital levels or even the SLR needs to be calibrated to reflect the market risk of the asset. 

Just for the record, we don't think most banks should own mortgage-backed securities (MBS) at all. Reserves at the Fed or T-bills should be ignored for the SLR calculation, but longer duration assets such as 30-year Treasury bonds or MBS should not. Just remember that Silicon Valley Bank had 40% of total assets in variable duration MBS during the most dramatic period of interest rate volatility in a century.

The familiar chart below shows the swings in the total duration of $2.7 trillion in Ginnie Mae securities after the 2019 panic and policy pivot by Fed Chairman Jerome Powell. The subsequent explosion of COVID and the Fed's response drove average US home prices up by over 50% in just four years. SVB was actually dead two years before it failed, but nobody at the Fed or other regulators noticed. Now you know why the Fed and other regulators sit on bank performance data for more than two months after the end of the quarter.  

Ginnie Mae Duration Index

Source: Bloomberg

The big problem facing US banks is not a lack of capital, but rather too much Treasury debt and an increasingly dysfunctional market for financing the needs of the US government. No surprise then that comments by Roberto Perli, Manager of the System Open Market Account (SOMA) and a senior leader in the New York Fed's Markets Group, drew a great deal of attention last week.

Perli’s carefully scripted remarks revealed the growing fragility of the Treasury market, so much so that the FRBNY felt compelled to publish carefully edited discussion of excerpts of his report in a subsequent blog post. Since most economists ignore the Fed’s balance sheet and the central bank’s interaction with the Treasury General Account, public market commentary about monetary policy and also bank regulation is incomplete. Perli described the market action after the announcement of tariffs by President Trump:

“Initially, Treasury yields dropped, in a classic flight-to-safety pattern. After a few days, however, longer-term Treasury yields started to rise sharply. One factor that appears to have contributed to this unusual pattern is the unwinding of the so-called swap spread trade. Reportedly, many leveraged investors were positioned to benefit from a decrease in Treasury yields of longer maturity relative to equivalent-maturity interest rate swaps, partially due to the expectation for an easing of banking regulation that would bolster bank demand for Treasuries. Since swap spreads are defined as the swap rate minus the Treasury yield, leveraged investors were making a directional bet that swap spreads would increase.”

Perli then described how the Treasury market became unstable when the market reversed and yields rose:

“However, on the heels of the tariff announcement, swap spreads started to decline and made the swap spread trade increasingly unprofitable. Because this trade is usually highly leveraged, prudent risk management dictated that the trade should be quickly unwound, which is what appears to have happened. The unwinding involved selling longer-term Treasury securities, which likely exacerbated the increase in longer-term Treasury yields.”

Perli was at pains to say that the March 2020 Treasury market collapse was far worse than the media kerfuffle caused by President Trump’s tariff announcement earlier this year. Yet his description of the violent unwind of the basis trade that is used to finance most Treasury auctions should give banks, investors and policy makers great pause.  Investors assumed a flight to quality but instead got higher Treasury yields. Hello.

The good news is that the Fed and Treasury are likely to eventually push for a change in the SLR to encourage banks to own at least short-term Treasury securities, which have little duration risk. The bad news is that the growing federal deficit and related dysfunction in the Treasury market will eventually mean that the government will look to banks to buy more and more Treasury issuance, including long-duration securities with considerable market risk.

The tendency of the Fed to facilitate the Treasury's needs goes back to the inception of the central bank and WWI, as we discuss at length in "Inflated." We write: "The expansion of the Board of Governors as an independent agency in Washington not only influenced the evolution of the banking system and the currency, but also played an important role in the trend toward central planning and authoritarian political structures in Washington during and after the 1930s."

Former Fed Governor Kevin Warsh told a conference at the Hoover Institution earlier this year:

"The Fed has acted more as a general-purpose agency of government than a narrow central bank. Institutional drift has coincided with the Fed’s failure to satisfy an essential part of its statutory remit, price stability. It has also contributed to an explosion of federal spending. And the Fed’s outsized role and underperformance have weakened the important and worthy case for monetary policy independence."

It is relatively easy for Warsh and other critics of the central bank to make such assessments, but it needs to be said that the Fed's actions in 2008 and again in March 2020 were largely driven by the sole mandate of the central bank -- to keep the Treasury market opening and functioning. The dual mandate of full employment and price stability has not really mattered to the Fed since 2008, when its role as banker to the United States again became primary, as during WWII.

Until Washington and most American economists stop pretending that the federal debt is sustainable or even manageable, the US economy and private banks are in growing danger. Markets are continuous until they're not. People who talk about increased bank capital as a protection against growing volatility in the Treasury market are fooling themselves and one another.

The Trump Administration should not underestimate the gravity and the threat of the change facing the Fed in the event that President Trump appoints a new chairman. As with other agencies, the Fed staff in Washington would likely be cut back severely. We could easily see Jerome Powell finish out his term as governor through 2028 just to prevent Trump from naming Kevin Warsh or another conservative to the central bank. But no matter who President Trump names as Fed Chairman, the single imperative to keep open the Treasury market will remain paramount.

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