As U.S. banks look to increase loans to offset earnings pressure from low interest rates, some are grappling with the consequences of the sharp balance-sheet growth experienced during the COVID-19 pandemic. Although U.S. banks have significant excess capital as measured by risk-weighted assets, some, particularly the global systemically important banks (GSIBs), are facing greater regulatory capital constraints on a non-risk-weighted basis. Two key capital ratios have come into focus of late: the enhanced supplementary leverage ratio (SLR), applicable to the GSIBs and their main bank subsidiaries, and the Tier 1 leverage ratio, which is applicable to all bank holding companies and subsidiary banks (see appendix for a detailed explanation of these ratios).

Bank balance sheets have grown over the past year as a direct result of the Federal Reserve's massive liquidity support of the financial system. From early March 2020 through August 2021, the Fed's balance sheet doubled in size to roughly $8.3 trillion. During this same time frame, U.S. bank deposits increased by about 30% to more than $17 trillion. As a result, the SLRs and Tier 1 leverage ratios of some banks and their subsidiaries, particularly those that have garnered large shares of deposits, have become more binding than their risk-based measures and in some cases are approaching the minimum required levels.

Those banks that are pushing up against minimum required leverage ratios have various tools at their disposal to ease this constraint. One direct approach is to push deposits off balance sheets, either by not accepting new deposits from certain types of larger commercial depositors (with possible negative business consequences) or convincing customers to park excess funds in off-balance-sheet money market accounts. Management teams could also issue bank-level preferred shares, assuming the leverage constraint is at the bank level. But this option limits the fungibility of these funds and would not count toward fulfilling total loss-absorbing additional capacity (TLAC) needs.

Another strategy to bolster leverage ratios is to invest the proceeds of holding-company-issued debt at the bank, which is typically the entity with leverage ratio constraints. Although this helps bolster bank leverage ratios by augmenting equity at the bank level, it also creates higher double leverage, a ratio computed as a holding company's investment in a subsidiary divided by holding company equity (see appendix for further details). If double leverage runs too high, banks' ability to make payment on outstanding debt could come into question.

Rather than deploying those strategies, banks could also simply retain more of their earnings by limiting share repurchases, allowing them to more quickly grow equity, which in turn would help lift their leverage ratios. In fact, we believe all of the GSIBs could maintain buffers of at least 25 basis points (bps) over their minimum SLR and Tier 1 leverage requirements and 50 bps above their risk-based capital requirements through earnings retention, even if their balance sheets grew quite materially. Assuming 10% growth over the next year, we estimate that only two of the GSIBs would have to retain any earnings to maintain those buffers, as shown in table 1.

Banks' balance sheets may also soon get some relief with the Fed now weighing tapering measures whereby it would gradually or completely stop purchasing new assets, which would greatly slow or halt the growth of its balance sheet. This in turn would at the very least slow the trajectory of bank deposit growth.

Calculation Changes Also Bring Leverage Into Focus

Another reason leverage ratios are coming into focus is the expiration of the Fed's temporary easing of the SLR calculation. In March 2020, the Fed announced a temporary change to its SLR rule to ease pandemic strains in the Treasury market and increase banks' ability to provide credit to households and businesses. Specifically, it excluded U.S. Treasury securities and deposits at the Fed from the SLR calculation but made no change for the Tier 1 leverage ratio calculation.

At the end of March 2021, the Fed allowed this temporary easing to expire as scheduled, so Treasuries and Fed deposits are once again included in the SLR calculations for all banks except for trust banks, for which Treasuries had been excluded as stipulated in the finalization of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2019. For this reason, trust banks face constraints on Tier 1 leverage at the subsidiary bank level rather than on SLRs.

Certain banks have expressed hope that regulators will soon alter how they set the minimum requirements for the enhanced SLR to make it less restrictive. Currently, the Fed requires the GSIBs to maintain a 3% SLR plus a 2% buffer to arrive at the 5% requirement at the holding company, in addition to the 6% requirement at the bank level. (The Fed requires what it considers category II and III banks, essentially non-GSIBs with respectively at least $700 billion or $250 billion of assets, to maintain an SLR of 3% rather than the higher enhanced ratio. It does not apply any SLR requirement to banks smaller than that.)

The Fed said earlier this year that it planned to invite public comment on several potential SLR modifications, but it is unclear what they may be and when that might occur. Notably, in 2018, regulators proposed to change the current enhanced SLR calculation by replacing the 2% buffer for the holding company (on top of the 3% minimum) with a measure of 50% of each bank's GSIB surcharge. That would effectively lower the requirement for all GSIBs based on the current GSIB surcharges (though those could rise over time). The proposal also called for dropping the 6% SLR requirement at the bank level and instead matching the minimum to that required at the holding company (3% plus half of the GSIB surcharge). That proposal was never finalized.

Ratings Considerations

Leverage ratio constraints could affect bank ratings in several ways. First, although we primarily rely on our proprietary risk-adjusted capital ratio to assess the strength of banks' capital, we also assess the strength of regulatory capital ratios. Indeed, from a ratings standpoint, we would look unfavorably on a bank that comes close to breaching a regulatory minimum capital ratio. If severe enough, it could result in a cap on our rating on the bank. While non-risk-based ratios have become more constraining, we do not expect any of the GSIBs to come close to breaching a minimum.

We also consider in our ratings a bank's double leverage ratio. One rating outcome of a persistently high double leverage ratio is that we could widen the notching of the holding company rating if we believed liquidity at the holding company were insufficient to make debt repayments without relying on the upstreaming of dividends from a subsidiary, which could be held back due to regulatory issues. We typically view double leverage of 120% or higher as a sign of potential liquidity challenges at the holding company. However, we believe all the GSIBs--even those with double leverage around or above that level--currently have adequate liquidity, and we think there is a low probability that we will widen the notching absent a material rise in double leverage or diminishment of liquidity.

We also would consider to what extent strategies to control balance-sheet size--such as turning deposits away--would harm the bank's business or earnings. We believe some banks have successfully reduced noncore and nonoperational deposits in the past without any material impact on their businesses or earnings. However, we would have to gauge the complexity and effects of such a move in the future.

Assessing Banks' Current Capital Constraints

Table 1 shows our estimate of the most binding capital constraint for each U.S. GSIB and its main subsidiary bank. It also shows the amount of growth that would cause a breach of the respective minimum, assuming no change in capital. (That growth relates to the denominator of the respective binding constraint ratio--either risk-weighted assets, assets, or leverage exposure.)

We also estimate the proportion of earnings each GSIB would have to retain (relative to the earnings reported in the year ended June 30, 2021) if it experienced growth of 10% to maintain at least a 25 bps cushion over its SLR and Tier 1 leverage requirements and a 50 bps cushion over its risk-based capital requirements. (We apply that 10% growth rate against the denominator of each capital ratio.)

Table 1

At the consolidated level, JPMorgan is the most constrained by SLR. Holding constant its Tier 1 capital from the second quarter of 2021, it could grow its nonoperating holding company (NOHC) leverage (SLR) exposure only 8% before it would breach the 5% minimum SLR requirement. (Conversely, at its second-quarter leverage exposure, it could shrink its capital by 8% before breaching the minimum.) At the bank level, it could grow its leverage (SLR) exposure only 6% before breaching the 6% required level.

Morgan Stanley is also constrained by the SLR, but it has a much larger cushion than JPMorgan. All the other GSIBs at the consolidated level are still constrained by risk-based ratios, with Wells Fargo and Bank of New York Mellon having the most room to grow.

However, at the subsidiary bank level, where the deposit growth is largely housed, most of the GSIBs are constrained by the SLR, while the trust banks are constrained by their bank Tier 1 leverage ratios.

None of the regional banks we rate seem close to breaching a leverage ratio constraint.

Assessing Double Leverage And Holding Company Liquidity

One of a bank's solutions for a bank-level leverage ratio constraint is to invest NOHC-issued debt as equity at the bank level, creating double leverage. We pay particular attention to holding company liquidity when the double leverage ratio breaches 120%. Our calculation for NOHC liquidity is a point-in-time calculation not including future dividends from subsidiaries, since it is possible regulators would disallow banks from upstreaming dividends if the subsidiary's financial stability weakened. Having enough liquidity on hand to cover at least 12 months of upcoming expenses, debt interest payments, and shareholder dividend payments protects against the risk that subsidiaries would be unable to upstream dividends (see appendix for further details on calculations). We would look favorably on ratios of liquid assets to liquidity needs well in excess of 1x, but there could be additional factors, such as a significant amount of debt coming due after the first year, that could result in downward rating action.

Table 2 shows the double leverage ratio and holding company liquidity metrics as of June 30, 2021, for the GSIBs. Calculating these adjusted metrics is a more complicated endeavor for the eight GSIBs than for the regional banks, since the GSIBs have formed intermediate holding companies (IHCs) as part of their living wills. Most of their holding company liquidity is kept at the IHC to avoid legal ramifications if a resolution were to be needed (see "What The Biggest U.S. Banks' Revised Living Wills Mean For Ratings," Oct. 5, 2016). With this in mind, to derive GSIB adjusted liquidity and double leverage metrics, we combine the liquidity and certain other parts of the balance sheet at both the NOHC and IHC.

Table 2

Profitability Pressure And The Need For Loan Growth Also Affect Leverage

Bank preprovision profitability will likely remain under pressure in 2021 because of low interest rates, though reserve releases have significantly aided bottom-line earnings. Slow loan growth has increased earnings pressure as companies remain hesitant to put capital to work in an uncertain economy--and if they opt to do so, many use the capital markets to fund loan growth.

Although GSIBs will welcome loan growth when it comes, some need to be careful to ensure such growth does not further pressure their leverage ratios. As such, until the Fed's balance-sheet growth slows substantially or reverses, or until a new approach to the ratio calculation takes effect, leverage ratios will likely be front and center as bank management teams carve a path to higher profitability.

Appendix: A Summary Of U.S. Bank Regulatory Capital Ratios

Risk-based capital ratios

Risk-based capital ratios--common equity Tier 1 (CET1), Tier 1, and total capital--measure a bank's ability to absorb losses on both on-balance-sheet and off-balance-sheet exposure by assigning various risk weights to the assets the bank is exposed to, depending on their riskiness. The minimum risk-based requirement for most are as follows:

• For CET1, Tier 1, and total capital ratios, the minimum requirements are 4.5%, 6.0%, and 8.0%, respectively, plus a capital conservation buffer of 2.5% and a countercyclical buffer (currently zero).
• For the larger banks, the capital conservation buffer has been replaced by a stress capital buffer with a minimum of 2.5%, but the buffer could be higher depending on their performance on the annual stress test.
• The eight largest banks--the GSIBs--are also subject to a GSIB buffer based on various metrics, including their size and complexity.

Tier 1 leverage ratio.  The Tier 1 leverage ratio does not risk-weight assets and measures a bank's ability to take losses on its balance-sheet assets. It is applicable to all banks and is computed as Tier 1 capital to average total assets, excluding goodwill and certain other items. For all banks (except community banks), the minimum is 4% at the consolidated level and 5% to be considered well capitalized at the bank level.

Supplementary leverage

The supplementary leverage ratio measures a bank's ability to take losses on its total assets--both on balance sheet and off balance sheet. It is a regulatory input only for banks with over $250 billion in consolidated assets. The ratio is computed as Tier 1 capital to total leverage exposure, with the denominator inclusive of both on-balance-sheet and off-balance-sheet assets such as derivatives. For the GSIBs, the enhanced supplementary leverage ratio minimum is 5% at the consolidated entity and 6% at the bank level to be considered well capitalized.

Double leverage

Double leverage is defined as holding company investments in subsidiaries divided by holding company (unconsolidated) shareholders' equity. Double leverage renders the NOHC dependent in part on dividends to meet interest payments on external debt. High double leverage may increase the possibility of liquidity stress, but the risk of a downgrade could be reduced by adequate liquidity at the parent.

NOHC liquidity calculation

We look at holding company liquidity from public information, by taking liquidity currently available at the holding company and dividing this figure--as disclosed by the Y-9LPs--by the holding company's last 12 months of expenses (including interest payments) and dividends, plus debt due over the next year. We note that this is a static ratio and that the amount of debt due over the coming year can change significantly year to year, affecting our holding company liquidity calculation.

Related Criteria

• Group Rating Methodology, July 1, 2019
• Risk-Adjusted Capital Framework Methodology, July 20, 2017
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Industry Report Card: Reserve Releases Should Continue To Push Large U.S. Banks' Profitability Higher, Aug. 17, 2021
• Fed Stress Test Results Give Banks Room To Release The Capital They Built Up During The Pandemic, June 28, 2021
• What The Biggest U.S. Banks' Revised Living Wills Mean For Ratings, Oct. 5, 2016