Regulatory change set to boost Treasury market resilience
Senior traders say a proposed watering down of bank leverage requirements should bolster the resilience of the US$28trn Treasury market by increasing banks’ ability to act as shock absorbers during times of heightened volatility, even if it’s not clear how much they'll boost their holdings on a day-to-day basis.
Last month, US regulators proposed changes to the enhanced supplementary leverage ratio – often referred to as eSLR – on global systemically important US banks in an effort to improve liquidity in the world’s most important bond market.
Goldman Sachs estimates that reducing the eSLR ratio from its current 5% to 3.5%–4.5% should increase balance sheet capacity by up to US$5.5trn among large US banks.
Theodore Kalambokidis, strategist at Societe Generale, said banks aren’t necessarily going to use all their additional capacity on holding Treasuries. However, the proposals are significant given the expected rise in US debt issuance following the passage of president Donald Trump’s One Big Beautiful Bill Act.
“This proposal will help [additional Treasury supply] get absorbed by G-SIBS more easily – especially during times of market stress,” said Kalambokidis.
“These changes should lessen the capital burden of holding Treasuries for banks so that market liquidity can improve and the [Federal Reserve] is less likely to need to step in [as lender of last resort].”
Design grumbles
The eSLR was an important part of the Basel III capital rules implemented in the aftermath of the 2008 financial crisis to improve the resilience of the banking sector. But banks have long grumbled about the design of the rules, which set minimum requirements on bank leverage irrespective of the riskiness of the assets they hold.
By not differentiating between low-risk and high-risk assets, banks say the eSLR has discouraged them from holding safer securities like government bonds. That in turn has prevented them from absorbing flows from clients selling bonds during volatile periods.
There have been several examples of those over the years. Most recently, the Treasury market faced one of the steepest selloffs in two decades after Trump announced his sweeping tariff policy on April 2 – causing 10-year Treasury yields to jump from 4% to 4.5% in a week amid fears his approach to international trade would reignite inflation.
Traders say relaxing the leverage requirements would make it easier for banks to act as buffers during these periods.
“At moments of stress, we could step in more. That's a fact,” said a senior macro trader at a US bank on potential changes to leverage rules. “[It means that] when you have forced sellers, you can stand against that as a marketmaker. It will give us more flexibility.”
Exemption pressure
Regulators have a real-life example to back up this theory. The Fed temporarily excluded Treasuries from banks’ leverage requirements for 52 weeks in a bid to improve market liquidity following heightened volatility in 2020 at the outbreak of the pandemic.
During the first week of the exemption, Treasury positions increased by roughly US$3.4bn per bank for every 1% reduction in leverage requirements, according to the Federal Reserve Bank of Boston – equivalent to about 10% of a bank's average weekly Treasury holdings. That experience fuelled calls for the leverage ratio to be permanently recalibrated.
“Leverage is typically the key driver as to whether banks hold more, or engage more, in Treasuries,” said Minal Chotai, head of cost and capital analytics, at Coalition Greenwich. “Under the Fed’s proposal, there is a fair drop in the enhanced leverage ratio requirements meaning there's obviously now a lot more capacity for banks to be able to facilitate US government bond trading activity.”
Debt explosion
The reforms come as the Treasury market is set to grow after more than doubling over the past decade. Primary dealer balance sheets, by contrast, have increased by a more modest 29% over the same period, according to the US Department of the Treasury. Banks hold an aggregate US$2.3trn in Treasuries – less than 10% of the entire market – according to Sifma data.
In January, the Congressional Budget Office projected that US national debt would reach US$52trn by 2035 – an 85% increase over 10 years, with an annual growth rate of 5.7%. Amrut Nashikkar, fixed income strategist at Barclays, said the eSLR reforms are “really positive for the Treasury ecosystem”, given banks won’t be as limited by balance sheet concerns as they were previously.
Still, “the real issue is supply, given the Treasury market continues to grow at a very rapid pace due to the US running a massive fiscal deficit”, he said.