The Federal Reserve’s decision last week to advance a long-anticipated proposal to ease the enhanced Supplementary Leverage Ratio (eSLR) for global systemically important banks (GSIBs) marks a potentially transformative moment for U.S. fixed income markets.
The rule, originally instituted post-2008 to ensure that large banks held sufficient capital against all assets—regardless of risk—has long been criticized for discouraging banks from holding low-risk securities such as U.S. Treasurys. In the wake of heightened Treasury issuance and recent episodes of market dysfunction (such as the 2019 repo spike and March 2020 liquidity crunch), regulators have sought to rebalance this dynamic.
The proposed change would replace the static 2% leverage buffer at the holding company level (and 6% for insured depository subsidiaries) with a variable requirement calibrated to a bank’s systemic risk score. While seemingly modest in scope, the rule would reduce aggregate capital requirements for GSIBs by an estimated 1.4%, and more notably, lower capital requirements at the subsidiary level by approximately 27%. Although this capital remains largely within the banking group, its reallocation could meaningfully alter how dealers engage in U.S. government bond and repo markets.
Implications for Treasury and Agency MBS Liquidity
From a fixed income investor’s lens, this rule change could materially improve market functioning. By reducing the capital cost of holding Treasurys and repo exposures, GSIBs may be more willing to expand their balance sheet commitment to primary dealer operations. This could ease persistent frictions in Treasury trading—particularly during periods of heightened supply—and help stabilize pricing through narrower bid-ask spreads and increased market depth.
Liquidity-sensitive strategies, including those employed by mutual funds, ETFs, insurance portfolios, and liability-driven investors, stand to benefit. Better-functioning repo markets may also lower the cost of leverage for hedge funds and mortgage REITs, while providing more robust collateral channels for cash management desks.
Caveats: Risk-Taking, Regulatory Arbitrage, and Market Overreliance
However, the improved liquidity comes with cautionary flags. If banks use the capital relief to facilitate more basis trades—where hedge funds arbitrage the spread between Treasury cash securities and futures, often through highly levered repo financing—market stability could become increasingly dependent on leverage-fueled intermediation. This dynamic contributed to the dislocation seen in March 2020.
Further, with capital buffers tied to risk scores rather than fixed minimums, there may be opportunities for regulatory arbitrage that allow banks to appear less systemically risky without materially changing their risk profiles. Investors should closely monitor how capital is deployed under the new framework and whether it leads to meaningful changes in liquidity provisioning behavior.
Supply Side Still Dominates the Long-Term Narrative
Notably, the proposed rule does not address the broader structural headwind in fixed income markets: the massive and sustained increase in Treasury supply. The U.S. government’s fiscal path continues to demand a deep and resilient investor base for duration absorption. Even with improved dealer capacity, the scale of net issuance—combined with limited foreign and Fed demand—means the market must still adjust to higher term premia and potentially more volatile price action, particularly at longer tenors.
Constructive but Not a Cure-All
The Fed’s proposal represents a constructive step toward improving secondary market functioning and incentivizing banks to serve as stronger liquidity providers. For fixed income investors, the changes may enhance execution quality, reduce market volatility during stress periods, and support a more stable Treasury ecosystem. However, the benefits come with systemic trade-offs.
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