The Leverage Ratio Loophole: Why Exempting Treasuries is Critical to Avert Treasury Market Collapse

The U.S. Treasury market, the world's deepest and most liquid debt market, is teetering on the edge of a liquidity crisis. At the heart of this vulnerability lies a regulatory artifact: the Supplementary Leverage Ratio (SLR) and its variants, which have evolved from a “backstop” to a binding constraint on banks' ability to intermediate in Treasury markets. With federal debt projected to hit 112% of GDP by 2030, the urgency to exempt Treasuries from leverage ratios has never been clearer. Failure to act could trigger a self-reinforcing cycle of illiquidity, higher borrowing costs, and systemic instability.

The 2020 Crisis: A Blueprint for Relief

The 2020 pandemic exposed the fragility of the Treasury market. As investors scrambled to convert risky assets into cash, liquidity evaporated, and the Merrill Lynch Option Volatility Estimate (MOVE) index—a gauge of Treasury market volatility—spiked to its highest level since the 2008 crisis. The Federal Reserve's temporary exemption of Treasuries and reserves from SLR calculations from April 2020 to March 2021 was a lifeline. This move boosted banks' effective SLR ratios by over 1 percentage point, enabling them to increase Treasury holdings by $3.4 billion for every 1% reduction in their SLR constraint. The result? A 40% decline in the MOVE index, narrower bid-ask spreads, and a return of liquidity.

The Current Regulatory Straitjacket

Despite this success, the exemption was never made permanent. Today, leverage ratios remain the primary constraint for Global Systemically Important Banks (GSIBs). The Enhanced Supplementary Leverage Ratio (eSLR)—which mandates a 3% ratio plus a 2% buffer—has become a chokehold. For instance, JPMorgan Chase's SLR dropped to 4.1% in early 2024, just above the 4% minimum, even without holding Treasuries.

The problem is twofold:
1. Non-risk-sensitive: Leverage ratios penalize banks for holding “safe” Treasuries as if they were subprime mortgages.
2. Exponential debt growth: The Congressional Budget Office projects federal debt held by the public to rise from $30.1 trillion in 2025 to $52.1 trillion by 2035—a 73% increase in a decade. This will require banks to absorb an additional $2 trillion in Treasury issuance annually, yet their balance sheet growth has lagged at just 3.8% annually since 2013.

Quantifying the Impact of Exemptions

Exempting Treasuries from leverage ratios would free up $1.2 trillion in balance sheet capacity for GSIBs by 2025, according to Federal Reserve microdata. For context:
- A full exemption would boost average SLR ratios by 5.48 percentage points, eliminating binding constraints for 80% of GSIBs.
- This would enable banks to increase Treasury holdings by $340 billion annually, closing the gap between issuance growth and intermediation capacity.

The math is stark: without reforms, the Treasury market's liquidity will deteriorate as issuance outpaces banks' ability to intermediate. The MOVE index could rise permanently, pushing Treasury yields higher and destabilizing everything from mortgage rates to corporate borrowing costs.

The Clock is Ticking

Policymakers are aware of the stakes. The Federal Reserve has proposed recalibrating the eSLR buffer to 50% of the GSIB surcharge—a move that would still leave ratios binding 50% of the time. Bipartisan legislation, such as the Treasury Market Resilience Act, seeks permanent exemptions for Treasuries and reserves. Yet delays persist.

The market is already pricing in the risk. The MOVE index has risen 25% since mid-2023, signaling growing anxiety. Without action, we risk repeating 2020's liquidity crisis—but this time, with a debt load 10% larger as a share of GDP.

Investment Implications

1. Short banks exposed to leverage constraints: Institutions like Citigroup and Bank of America, which operate near their SLR limits, face rising capital costs and reduced earning asset growth.
2. Long Treasury ETFs (TLT, IEF): A permanent exemption would stabilize liquidity, reducing volatility and supporting prices.
3. Avoid duration-heavy insurers: Companies like MetLife or Prudential, whose equity is sensitive to Treasury yields, could face margin calls if yields spike due to liquidity shortages.

Conclusion: Act Now or Pay Later

The Treasury market is the bedrock of global finance. Exempting Treasuries from leverage ratios is not a radical proposal—it's a proven solution. The 2020 exemption worked; making it permanent would cost regulators nothing but bureaucratic inertia. Investors should prepare for two scenarios:
- Best case: Policymakers act, liquidity improves, and Treasury yields stabilize.
- Worst case: Inaction leads to recurring crises, higher borrowing costs, and a market primed for volatility.

The choice is theirs—but the clock is ticking.