Market News

BY Szu Ping Chan

They are supposedly the world’s safest bet. US government-issued debt, known as Treasuries, are a bedrock of the global financial system, with $900bn (£670bn) of bonds changing hands every day across a market worth nearly $30tn.

But with pockets of the market showing signs of stress, the Trump administration wants to make bond-buying great again.

Regulators have proposed rewriting the post-financial crisis rulebook in what would be the biggest shake-up since 2008. The change would allow America’s banking titans on Wall Street to effectively exempt Treasuries from the calculations about how risky their balance sheets are, allowing them to buy more US debt because they are no longer penalised for owning it.

Yet there was warnings that giving US banking forces an easier ride could unleash havoc again – so what could go wrong? And how far could any crisis spread?

The argument is simple. After the global meltdown of 2008, there was a worldwide effort to ensure banks had enough stashed away for a rainy day to withstand another major shock. In America, regulators made the biggest banks go the extra mile and put aside bigger buffers on top of the myriad other capital cushions.

It means that while most banks around the world have to hold extra capital worth 3pc of their overall assets, for the biggest titans on Wall Street, that proportion is 5pc. This means the more bonds like Treasuries a bank owns, the more capital it must put aside to back this debt in case it fails.

The riskiness of these investments is also disregarded, meaning highly risky junk bonds and safe-as-houses Treasuries are treated the same in the eyes of the rules, which are known as the “supplementary leverage ratio” (SLR).

Since it was introduced, the SLR has been criticised for treating Treasuries as riskier than they actually are. Investors refer to Treasuries as “risk-free” – because there is almost no chance the US will not repay the debt – but the SLR disregards this and computes them as more dangerous.

Part of this is intentional and means banks around the world have an extra, easy-to-calculate buffer on top of the framework of other capital requirements that are linked to risk.

However, America’s biggest banks say the crude calculation stops them from snapping up US Treasuries during times of stress, because doing so comes at too high a price.

Jamie Dimon, the boss of JP Morgan, has warned that this blunt instrument means US Treasuries are branded “far riskier” than the reality.

“These rules effectively discourage banks from acting as intermediaries in the financial markets – and this would be particularly painful at precisely the wrong time: when markets get volatile,” he wrote in his annual letter to shareholders.

Scope for change

Scott Bessent, the US treasury secretary, is pushing for change and has claimed that tweaking it could drive US borrowing costs down, helping the world’s biggest economy to service its mountain of debt. More importantly, it could help to support US bonds at a time when foreign investors are increasingly losing faith.

Ken Rogoff, the former chief economist at the International Monetary Fund, agrees that there’s scope for change.

He says: “It is very hard to give a clear rationale for the SLR, which is essentially an extremely crude way to stop banks from over-leveraging and has led to all kinds of distortions in the market because large global banks can no longer perform simple arbitrage functions as they used to do.”

Jerome Powell, the Federal Reserve chief who is currently at war with Trump over interest rates, is singing from the same hymn sheet as the president, describing it as “prudent” to reconsider the rule given the growth in safe assets on bank balance sheets over the last decade.

And so it begins. Last month, the Fed proposed rule changes that would move away from a crude approach and instead tie the amount of capital banks must set aside to how important it is to the global financial system.

It also left the door open to even bigger changes that would completely exclude low-risk assets such as Treasuries and central bank deposits from the leverage ratio calculation – as was the case during the pandemic – inviting feedback on whether this could be done as an “additional modification”. As it stands, the changes are set to free up an extra $5.5tn on bank balance sheets that can be put to work.

The Fed estimated that capital requirements at the deposit taking arms of the biggest banks would fall by an average of 27pc.

However, the move to change the SLR and return to pre-crisis rules has proved highly controversial for those who lived through the last financial meltdown.

Sheila Bair, who used to run the Federal Deposit Insurance Corporation (FDIC), which insures savers against losses in the event of a bank failure, warns that such a move is storing up trouble for the future.

After all, the collapse of Silicon Valley Bank (SVB) in the US and the fire sale of its UK subsidiary to HSBC in 2023 was rooted in the SVB’s purchases of US Treasuries.

SVB had kept a large portion of depositors’ cash in Treasuries, but as interest rates surged in the months leading up to its collapse, the value of these Treasuries plunged. The crisis that followed Liz Truss’s mini-Budget was also a crisis sparked by turmoil in the gilt market.

“Such a huge reduction will increase the risk of a [major] bank failure, exposing the economy to credit disruptions and exposing the FDIC and banking system to substantial losses,” Bair warns.

“I led the FDIC during the 2008 financial crisis and remember well how insured banks, with their higher capital requirements, ended up being a source of strength for the holding companies, not the other way around.

“The idea that somehow this freed-up capital will ... make its way back down to the insured banks in a crisis isn’t grounded in reality.”

Bair isn’t the only one who’s expressed concern. Fed governor Michael Barr, who served as the central bank’s top bank regulator before stepping down in the face of pressure from the Trump administration, warned the central bank’s proposals would “significantly increase” the risk of a big bank failure.

Bair’s big fear is that the money won’t end up being funnelled back into boring bonds at all, but end up lining shareholders’ pockets or in more exotic investments.

She says: “Banks will likely find a way to distribute some of it to shareholders, or otherwise deploy it into their market operations which are riskier and more vulnerable to crisis conditions than insured banks.”

Covid buffer

Those who back removing Treasuries from the calculations highlight that it was done during the pandemic without much fanfare as banks ploughed more money into bonds.

However, analysts at Morgan Stanley have highlighted that this was in part a function of a 21pc jump in bank deposits as workers had nowhere to spend their cash during lockdowns.

It recently noted: “The Covid-related surge in deposits means that 2020-21 is not comparable with today’s environment, as deposit growth is tepid at 1pc year on year. Deposit growth, combined with loan demand, are key drivers of bank demand for securities as banks will prefer to use deposits to support client lending activity and build client relationships.”

Bair says capital buffers were put there for a reason. “If there should be a future crisis, regulators have the authority to provide emergency temporary relief.

“[If they] reduce capital requirements now, they don’t know how banks may deploy it. Better to maintain strong requirements in good times so capital cushions will be there when bad times hit.”

Regulators are also keeping a close eye on this side of the Atlantic amid concerns we are moving towards a world where sovereign risk is completely removed from the leverage ratio. While the UK has already taken steps to remove central bank reserves from its calculations, officials here believe removing government bonds would be a step too far.

Rogoff, now a Harvard professor, agrees that capital buffers have served their purpose during times of crisis.

“It is notable how well the banking system held up during the pandemic, and later from the sharp rise in global interest rates. It is precisely when the system hits peak stress moments – especially when the economy is hit by completely out-of-the-box shocks – that the SLR suddenly does not seem quite so crazy,” he says.

The rules tweaks may look benign, but bond sell-offs are often quick and violent. And it’s usually the taxpayer left picking up the pieces.