Bank Capital Rules: The Hidden Threat to the U.S. Treasury Market

Ladies and gentlemen, buckle up! We're diving headfirst into the heart of the U.S. Treasury market, where the stakes are higher than ever. The market, once the epitome of stability and liquidity, is now facing an unprecedented challenge: the tightening grip of bank capital rules. These regulations, designed to safeguard the financial system, are now threatening to choke the life out of the Treasury market. Let's break it down!



The Capital Conundrum

The U.S. Treasury market, with $28 trillion in outstanding securities, is the world's deepest and most liquid securities market. But here's the kicker: since 2007, the total amount of Treasuries outstanding has grown nearly fourfold relative to primary dealer balance sheets. This means that while the market has ballooned, the capacity of primary dealers to provide liquidity has not kept pace. Why? Because post-crisis regulatory capital requirements have constrained dealers' ability to make markets effectively and reduced market depth.

The eSLR and Tier 1 Leverage Ratio: The Double-Edged Sword

The enhanced supplementary leverage ratio (eSLR) and Tier 1 leverage ratio are the culprits here. These regulations have driven down banks' leverage ratios, particularly affecting the three of the six largest bank holding companies that are bound by the eSLR. This prevents further Treasury purchases unless they reduce other assets or raise capital. When leverage ratios become binding, banks have the incentive to decrease low-risk activities, such as intermediating in Treasury and Treasury repo markets. This contraction in banking activity would worsen the effect of the initial market stress, amplifying damage to the broader financial system.

The Role of Primary Dealers

Primary dealers are the backbone of the Treasury market. They facilitate trades with a broad range of clients, including foreign central banks, asset managers, pension funds, and hedge funds. But their intermediation capacity has not kept pace with the growing Treasury market size. This trend continues due to large U.S. fiscal deficits and regulatory capital constraints.

The Rise of Principal Trading Firms (PTFs)

As capital constraints limit traditional intermediaries, Treasury market intermediation increasingly relies on principal trading firms (PTFs). However, PTFs operate with short-term strategies and, unlike primary dealers, are less willing to make markets during stress periods. Furthermore, PTFs principally provide liquidity for on-the-run Treasury issues, and liquidity for off-the-run issues remains dependent on dealer intermediation.

The Fed's Dilemma

The Federal Reserve is caught in a bind. With the yield on the 10-year Treasury spiking as high as 4.52% and the benchmark 30-year yield briefly touching 5.02%, the central bank may need to step in to stabilize the Treasury market. But with bank capital rules constraining dealers' ability to provide liquidity, the Fed's options are limited.

The Solution: Recalibrate the eSLR and Tier 1 Leverage Ratio

To preserve market functioning, bank regulators could simply recalibrate the eSLR and modify the Tier 1 leverage ratio. These adjustments are critical for enabling banks to accommodate the growing supply of Treasuries. But will they act in time? Only time will tell.

The Bottom Line

The U.S. Treasury market is at a crossroads. Bank capital rules, designed to safeguard the financial system, are now threatening to choke the life out of the market. The Fed must act decisively to recalibrate the eSLR and Tier 1 leverage ratio, or risk a market meltdown. Stay tuned, folks, because this is one story you won't want to miss!