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Regulatory relief erases $1 trillion of exposures from 6 banks

The Federal Reserve's decision to temporarily relax the calculation of a key capital ratio has reduced the size of six large national banks by $1 trillion in aggregate.

Critics of the regulatory relief say the figure demonstrates how much of a benefit the nation's largest banks received and highlights the danger of altering a capital ratio just as banks experience stress. Proponents of the relief call it a necessary move that allows banks to help an economy struggling to survive a pandemic.

On April 14, the regulator issued a rule that temporarily excluded Treasury securities and deposits held at Federal Reserve banks from the supplementary leverage ratio. At a July 29 press conference, Chairman Jerome Powell said the regulator wanted to make sure the relief was temporary and noted that other countries, such as Switzerland, Japan and Canada, have deployed similar measures.

"What it's doing is allowing them to grow their balance sheet in a way that serves their customers. That's really what it's doing," Powell said.

The move pushed second-quarter leverage ratios higher by dramatically reducing the size of banks' balance sheets. The nation's largest bank, JPMorgan Chase & Co., posted the largest quarter-over-quarter decline in total leverage exposures, shrinking $308.0 billion in a single quarter. Combined with five other large banks Bank of America Corp., Citigroup Inc., Morgan Stanley, Bank of New York Mellon Corp. and State Street Corp. balance sheets shrank by $1.045 trillion.

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"That really goes to show just how much of a giveaway this was to the banks," said Jeremy Kress, assistant professor of business law at University of Michigan who focuses on macroprudential regulation. Kress said that if regulators were primarily concerned about banks' ability to aid in the pandemic, they could have exempted any newly acquired Treasurys or deposits instead of exempting items already on banks' balance sheets. "The fact that the agencies chose to exempt everything is just a massive giveaway. It's a back-door reduction in across-the-board capital requirements."

Kress also said the change makes it difficult to compare banks' leverage ratios across time. Graham Steele, director of the corporations and society initiative at Stanford Graduate School of Business and a former employee of the Federal Reserve Bank of San Francisco, said the Fed's relief removes a key Dodd-Frank Act regulation just as the economy stresses bank's balance sheets.

"It feels like we chucked a bunch of those tools out now that we have an extraordinary situation," Steele said.

Custody banks Bank of New York Mellon and State Street experienced the largest increases in their supplementary leverage ratios thanks to the relief, posting linked-quarter increases of 265 and 288 basis points, respectively. Another relief measure specifically targeted for custody banks allows the companies to exclude balances held at central banks. Supplementary leverage ratios at megabanks JPMorgan, Bank of America and Citigroup increased by 60 basis points to 80 basis points.

Proponents of the relief call it a smart move to give banks the flexibility they need to aid the economy in a crisis. Applying the regulatory relief to the 34 depository institutions that reported a supplementary leverage ratio for the first quarter would free up $125.78 billion of Tier 1 capital.

"When we have times like this, we need to react to the environment and the challenges. I don't think changing the risk weighting around these items changes the risk profile to the banks that much," said Brett Rabatin, head of bank strategy for The Travillian Group, an advisory firm.

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The supplementary leverage ratio is a secondary issue in the Fed's approach to regulation, said Sean Campbell, chief economist for the Financial Services Forum, an industry group that represents the nation's largest banks. Campbell said the Fed's approach to stress testing, its suspension of share repurchases and the income test limit on dividends are far more significant measures that address the banks' ability to withstand the crisis. Ultimately, Campbell said, the leverage ratio, which does not account for the relative risk of assets, is a flawed ratio.

"Risk-insensitive capital metrics are problematic, period. Some say that's a feature, not a bug, but that's not a well-accepted point of view throughout the academic community or people who think seriously about bank regulation," he said.

Marty Mosby, director of bank and equity strategies at investment bank Vining Sparks, also called the leverage ratio a flawed metric, saying it can encourage risky behavior since it weighs high-loss content such as commercial real estate loans the same as Treasury securities. That would essentially reward banks for taking on riskier assets that pay more since the cost on the balance sheet would be the same for safer assets.

But Steele said there were risks in Treasury securities, noting that banks take on counterparty risk and can run into liquidity issues.

"One trillion is a significant amount of assets," Steele said. "That would be the fifth-biggest bank holding company in the nation on a stand-alone basis that is just not being accounted for."

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Click here to view the list of Category I, II and III depository institution subsidiaries that reported March 31, 2020, supplementary leverage ratios in Excel.