Repair the Leverage Ratio, Revive the Repo Market

Last March's market crash provided a real-time stress test for the banking sector's post-financial-crisis reforms. Mostly they passed. Bank capital ratios remained stable even though their share prices plummeted; there was no run on any major bank; some institutions which provisioned prudently have now written their provisions back into P&L.

But the strength of an individual bank is not the same as the strength of the financial system as a whole. And March's equity price collapse flashed up a danger signal about systemic financial stability that regulators should not ignore.

As equity prices plummeted, the prices of safe-haven assets fell too: investors were dumping high-grade US and UK government bonds in a frantic 'dash for cash'.

Tellingly, cash bond prices fell more sharply than futures. Dealers could have earned 8% yields without market risk simply by holding 10-year US Treasury notes, selling the futures and delivering the notes into their short futures position a few months later. But no-one appeared to have balance sheet capacity, and it was left to central bankers to intervene, with the Bank of England purchasing £200 billion of gilts and US authorities nearly $1 trillion of Treasuries.

Searching for an explanation of this dislocation between the futures market and the bonds, many commentators point to the leverage ratio. Banks can't raise equity capital whenever they please, so the leverage ratio puts a fixed cap on balance sheet volumes with no distinction between banking assets such as loans — which create money and leverage in the real economy — and liquidity assets like gilts, US Treasuries or government bond repos, which do not.

Concerns about the impact of the leverage ratio on bond markets are nothing new. The Bank of England published a working paper in 2018 outlining the impact of leverage constraints on banks' repo books. The Committee on the Global Financial System (CGFS), an arm of the Bank for International Settlements, published a report in 2017 which warned that balance sheet and leverage constraints could reduce bond repo markets' capacity to meet end-users' needs in times of stress.

In March last year, these warnings were realised: bond market liquidity evaporated; settlement fail rates rocketed; private sector institutions were unwilling to take on trading positions that would have normalised prices; hedge funds were unable to find financing.

The Financial Stability Board, in its report on the crisis, stated diplomatically that regulatory constraints 'may have' reduced dealers' intermediation capacity. The Federal Reserve immediately removed domestic government bonds from leverage in the USA, on a temporary basis, and consulted on the possibility of removing bond repo as well, as soon as it had completed its initial bond-buying.

But the leverage ratio is non-risk-weighted: exposures to all counterparties are treated equally. A simpler solution would be to remove domestic currency government bonds and bond repo entirely from leverage, irrespective of the counterparty, together with central bank deposits.

To prevent abuse and to control regulatory arbitrage, this exemption would need to be offset by closing a number of loopholes. The counterparty credit risk capital measures applied to repo need to be updated to match the most advanced Basel standards. Off-balance-sheet and synthetic repo transactions, which amount to many hundreds of billions of dollars in uncounted leverage, must be captured consistently with their on-balance-sheet cousins.

Adjusting the leverage ratio in this way would be consistent with the original goals of the Basel Committee on Banking Supervision, and would ease the tension in today's regulations between capital and liquidity. Holding first-class liquidity in greater volume would no longer mean tying up more capital or closing down a portion of the loan book.

By deepening private-sector cash and government bond markets, these adjustments would also make financial institutions less dependent on central bank liquidity support.

Government bond repo lies at the very heart of today's financial system. Central counterparties, central banks and asset managers all rely on repo to place cash into the banking system on a secured basis. Commercial banks use repo to provide liquidity to their clients. Market-makers use repo to fill short positions and to prevent delivery failures. Clearing house members use it to source collateral and to convert collateral into cash when needed.

Narrow leverage ratio exemptions, based around central bank deposits alone, create a centripetal drift in cash markets by incentivising banks to place liquidity centrally with the ECB, the Fed, the Bank of England or another central bank rather than lending it to one another and to their clients.

Recent events have validated regulators' early reactions to the last financial crisis: the 2020 pandemic created a health crisis and an economic crisis but not a banking crisis. However, March's market turmoil did expose the shallowness of liquidity in today's cash, bond and repo markets. Repairing the leverage ratio would be a constructive next step.

Repair is needed. If not now, when?