Didn't Notice The Proposed Changes To The SLR? Don't Worry, Most Markets Didn't Either

The US Treasury released its first report (under Trump) on re-examining financial regulations and their impact on economic growth. The publication was little noticed because most people don't much care about Supplemental Leverage Ratios (SLR), though they should.

For decades, regulators allowed banks to operate under Basel rules as if capital ratios were sufficient criteria for identifying risks, only to suffer the worst global monetary panic since the Great Depression. Some people did notice that banks like Bear Stearns and Lehman Brothers were by all regulatory standards "well capitalized," and yet, their balance sheets were hugely extended, often with leverage ratios of 33, even 35, to 1.

The ability of banks to be able to manipulate capital ratios was at the core of the eurodollar system's global expansion especially after 1995 (J.P. Morgan; RiskMetrics). If you understand what goes on in constructing a bank balance sheet (as I will go through in great detail in my upcoming series, Eurodollar University), there was no inconsistency in blown-out leverage ratios at seemingly "well-capitalized" banks.

This placed a great deal of importance on especially derivatives that served the function of "regulatory capital relief"; which simply means the ability to take whatever asset and describe it in the most charitable way possible so as to reduce the capital charge of that asset. This is not, as it may seem in my description here, utterly and totally nefarious; as with all things, even the best ideas can at times get far out of hand and be bastardized toward purposes either different or to extremes other than originally intended.

If a bank has a choice of lending in a mortgage at a 100% risk weighting or buying an MBS with similar characteristics at a 50% or even less risk weighting, the choice is obvious. Flipping the capital ratio around, for the same amount of capital a bank can hold double its leverage (hold twice as much assets) at a 50% ratio as 100%. Therefore, the ability to do that is paramount, even if capital ratios look pristine in each case.

To convert a 100% RWA to something less required largely derivatives.

That was, in essence, the role of credit default swaps before 2007. As AIG's 2007 Annual Report explicitly spells out (in the notes, of course, as almost all of this stuff goes on off-balance sheet and unrecordable under traditional accounting definitions and conventions):

Approximately $379 billion of the $527 billion in notional exposure on AIGFP's super senior credit default swap portfolio as of December 31, 2007 were written to facilitate regulatory capital relief for financial institutions primarily in Europe.

Again, derivatives used for expanding leverage while maintaining capital ratios, and spread out all over the world (though at the time primarily Europe and the US; Asia still might have to be reckoned with). This is what I call dark leverage or math-as-money. It is a money multiplier effect that has nothing to do with the amount of bank reserves, let alone vault cash or anything in the Ms.

The capacity of global bank dealers in the aggregate to supply these kinds of dark leverage is also paramount for monetary expansion - leverage. Credit default swaps were not the only method of obtaining "regulatory capital relief," nor was that the only balance sheet constraint. There is internal discipline often in volatility (or correlation) parameters like VaR, under which derivatives like interest rate swaps prove highly useful and for the same intentions.

The issue post-crisis with regard to derivatives has been tied almost always to regulations. I think that has happened as a matter of misunderstanding the true nature of the global banking system. Orthodox economics and current conventions surrounding money are outdated, but yet predominate in these discussions. Even Treasury's report on the subject betrays a lack of appreciation for the full depth of modern, 21st century global monetary organization.

Released on June 12, it suggested that the SLR might be reformulated to make it less imposing. The SLR was initially proposed so that the risk-weighting shenanigans (regulatory capital relief) would at least be exposed by this measure of true(r) leverage. It takes Tier 1 capital divided by the sum of on-balance sheet assets plus off-balance sheet exposures. There is still a large gray area in that latter variable.

Banks want now to deduct certain cash and liquid assets (including USTs) from it. The result of which is supposed to, in Treasury's estimation, unlock significant liquidity potential of the global banking system from just American operations. It is, in other words, the official acceptance of at least part of the idea that one big problem in the economy is insufficient liquidity (no sh@#).

The release of the report, while having no impact on the mainstream, may have had some in the places where we find conditions related to this modern liquidity format. Cross-currency basis swap premiums, particularly in yen, have become less negative again since June 13, rising to the least negative since 2015. The 30-year swap spread, consistently a loud example of systemic illiquidity of this type, amplified its decompression (less negative) at that same time.

For some, it is an indication that Treasury is right - regulatory constraints are holding back vital elements of global banking, really money dealing, and therefore, their removal is a legitimate path to normalcy.

I actually agree with the idea, just not in this case. What I mean is that the absence of monetary leverage through dark leverage and math-as-money is the primary global economic problem (see: interest rate fallacy), but the issue is not regulations so much as opportunity (I know I am a broken record on this point). The eurodollar system is not anchored by government intervention so much as broken by its own inherent contradictions. Normalcy is an option, and fixing banking meaning money is the way to get there, but it won't have anything to do with the SLR, Dodd-Frank, or the Federal Reserve as it is currently constituted.

If we look at other areas of liquidity, there was as the mainstream little or no notice at all of Treasury's proposal. The 10-year swap spread, for instance, records no change on or around June 12. Further, the move in the 30s isn't all that impressive, either.

Then there are other indications of, at the same time, the opposite. In other words, the view of liquidity from T-bills even after the release of Treasury's report doesn't support the notion that markets are enthused by possible changes in the SLR. Maybe that means this part of the "dollar" market doesn't believe it likely to happen, but if the 30s do, why would T-bills not?

Not only that, as I noted yesterday (subscription required), bills are more of a forward indication, whereas swap spreads are at most concurrent, more so lagging clues. The 30-year spread didn't turn negative in 2008 until late October, and didn't drop below zero consistently again until January 2015; in both cases, after "dollar" conditions had in actuality turned dangerous.

The trading in bills recently (up to June 23) and its relation to longer-dated USTs was actually reminiscent of the days and weeks leading up to October 15, 2014 - though not at all to the same degree.

It would be nice and easy if the government had that ability - to turn the "dollar" back on like the flip of a switch - even if it didn't appreciate the full extent of what it could do. If four QEs didn't work, however, then what is the chance the SLR would? Banks didn't need Dodd-Frank or any of its individual components to shed leverage because they learned the hard way the dangers of being so exposed (and thinking the Fed had it all covered) in such a condition (the contradiction). The unmeasurable risk/return ratio, which is what really matters, is what is upside down on this side of 2007. Changing the SLR will not, in my view, solve the problem, and I believe to this point a few weeks later the wide "dollar" market largely agrees.