Federal Reserve Proposes Capital Rule Changes to Boost Treasury Market Liquidity

The Federal Reserve has proposed changes to capital requirements for large U.S. banks, set to take effect from June 26, 2025. This move is expected to release up to $185 billion in capital, according to Morgan Stanley estimates. The adjustment aims to enhance liquidity in the U.S. Treasury market, which could have implications for various sectors, including cryptocurrencies.

The proposal, approved by a 5-2 vote under the supervision of Michelle Bowman, focuses on easing leverage rules for large banks. This change is anticipated to unlock approximately $60 trillion in balance sheet capacity, potentially freeing $185 billion. The core of the proposal involves modifying the 'enhanced supplementary leverage ratio' for global banks dealing with low-risk assets, such as Treasuries and reserves. This adjustment is designed to reduce the capital banks must hold against these relatively safe assets, encouraging them to act as market makers and thereby increasing liquidity in the Treasury market.

The proposal has sparked debates over systemic stability. Critics argue that reduced capital buffers could erode systemic resilience, particularly in a crisis. However, supporters counter that the changes ensure capital is better aligned with actual risks. The Fed's primary rationale for the proposal is to alleviate leverage ratio constraints on Treasury holdings, which could increase Treasury liquidity and stabilize yields. During periods of market stress, such as the 2020 "dash for cash," banks faced penalties for holding Treasuries, deterring their role as market makers. The proposed changes could reduce the capital penalty for holding Treasuries, potentially expanding banks' trading desks and narrowing bid-ask spreads.

The proposal also raises concerns about potential risks, including overleveraging, moral hazard, and global disparities. Lower capital requirements could incentivize banks to take on excessive debt, mirroring pre-2008 behaviors. Reduced buffers might embolden banks to pursue riskier strategies, assuming the Fed will bail them out. Additionally, the U.S. reforms could create an uneven playing field, pressuring non-U.S. banks to follow suit. Senator Elizabeth Warren has warned that this could "set the stage for another crisis," underscoring the political stakes.

The implementation timeline for the proposal remains unclear, but investors should monitor stress test results for clues on how banks might fare under adverse scenarios. Banks with high G-SIB surcharges, such as JPMorgan Chase and Bank of America, stand to gain the most from reduced buffers. Regional banks may benefit indirectly from improved liquidity conditions. Treasury-related instruments, such as the iShares 7-10 Year Treasury Bond ETF, could stabilize or outperform amid reduced volatility. However, investors should also consider the potential risks and monitor Fed communication for hints on buffer adjustments post-implementation.