Is the Federal Reserve’s Move to Loosen Leverage Requirements a Boon or a Risk for the Financial System?

The Federal Reserve’s 5-2 vote to advance a proposal easing capital requirements for the largest U.S. banks represents a major policy pivot with far-reaching implications.

The proposed changes would reduce enhanced supplementary leverage ratio (eSLR) requirements for global systemically important banks by up to 1.5 percentage points, potentially freeing up billions in capital.

Wall Street analysts estimate the move could unlock between $185 billion and $6 trillion in additional balance sheet capacity, fundamentally altering how major banks engage with the $29 trillion Treasury market.

The measure, currently available for public comment for 60 days, aims to align leverage ratios more closely with each bank's systemic risk profile, departing from a uniform approach.

This recalibration is designed to ensure that capital requirements serve as a true backstop, not a primary constraint on lending and market-making activities.

Could Eased Capital Rules Boost Treasury Market Liquidity?

A central aim of the Fed’s proposal is to enhance liquidity in the U.S. Treasury market, which has faced bouts of stress and dysfunction in recent years. By lowering leverage requirements, the Fed hopes to encourage large banks to hold more Treasuries and expand their market-making roles.

Acting Comptroller Rodney Hood emphasized that the changes would allow the leverage ratio to function as a backstop rather than a binding constraint, potentially improving the resilience of the Treasury market.

Vice Chair for Supervision Michelle Bowman described the plan as a critical step toward balancing financial stability with market efficiency. If successful, the rule change could make the Treasury market more robust in times of volatility, supporting the broader financial system.

Did you know?
The enhanced supplementary leverage ratio (eSLR) was introduced after the 2008 financial crisis to ensure that the largest banks maintained strong capital buffers, regardless of the riskiness of their assets. It was designed as a non-risk-based safeguard to complement traditional capital requirements.

Systemic Risk Concerns Divide Policymakers

Despite the intended benefits, the proposal has sparked sharp debate within the Fed and among policymakers. Two governors, including Michael Barr, voted against the measure, warning that reduced capital buffers could weaken the safety net for large institutions.

Barr argued that the changes “put our banking system at risk” without guaranteeing meaningful improvements in Treasury market resilience. External critics, such as Senator Elizabeth Warren, have also voiced concern.

Warren called the leverage rule a “critical safeguard” for financial stability, cautioning that the projected $210 billion reduction in bank-level capital could increase systemic risk and leave the financial system more vulnerable to shocks.

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Wall Street Welcomes Flexibility as Critics Urge Caution

Major banks and market participants have largely welcomed the Fed’s move, viewing it as a long-awaited modernization of capital rules that will unlock lending and trading capacity.

Institutions like JPMorgan Chase and Goldman Sachs stand to benefit from reduced minimum capital ratios, which could drop from 5% to as low as 3.5% for holding companies.

However, the proposal’s detractors warn that loosening capital requirements could erode the hard-won safeguards put in place after the 2008 financial crisis.

They argue that robust capital buffers remain essential for absorbing losses and maintaining confidence during periods of market stress.

The Road Ahead Hinges on Public Input and Market Response

As the 60-day public comment period begins, the ultimate impact of the Fed’s proposal will depend on feedback from stakeholders and ongoing market developments.

The central bank faces the challenge of fostering Treasury market liquidity without compromising the stability of the financial system. The debate underscores the delicate balance between regulatory flexibility and the enduring need for prudent risk management.

The coming months will reveal whether the Fed’s recalibration is a prudent response to evolving market dynamics or a risky gamble that could test the resilience of the U.S. financial system.