Beware the doom loop: New bank rules raise debt fears

The US is poised to weaken financial-crisis-era regulation of its biggest banks in moves aimed at shoring up its stressed government debt market.

The proposed changes could increase systemic financial risk – and not just in the US.

On Wednesday, the US Federal Reserve Board voted 5 to 2 on a proposal to lower what’s called the “enhanced supplementary leverage ratio”.

Risky move: Federal Reserve chairman Jerome Powell has backed the changes.Credit: AP

After the 2008 financial crisis, which had US banks at its epicentre, banking regulators around the world introduced a raft of regulations, the most significant of which were capital adequacy rules that required banks to hold minimum levels of capital against their risk-weighted assets.

To guard against manipulation of the rules (bigger banks make their own internal assessments of the riskiness of their assets), the regulators added a simple leverage ratio. They required banks to hold minimum levels of tier one capital – common equity, retained earnings, preference capital – against their total, unweighted, on- and off-balance sheet exposures.

For most banks that ratio is 3 per cent. (In Australia, the banking regulator has set it at 3.5 per cent.)

US bank regulation matters beyond America because of the dominance of the US dollar and the US financial markets within the global financial system.

Globally systemically important banks, or “G-SIBs” – those that could precipitate another global financial crisis – faced an additional impost, with most non-US banks having leverage ratios of between about 3.5 per cent and 4.25 per cent.

The US, having experienced the worst of the GFC and seen the cost to taxpayers of the bailouts of banks and non-bank institutions, imposed a minimum leverage ratio of 5 per cent.

Yet at the urging of not just the banking sector, but the Trump administration, the Fed now wants to lower that ratio to levels similar to those of the largest non-US banks. Such a move would, on some calculations, release more than $US210 billion ($322 billion) of capital from the eight big US banks deemed to be of global systemic importance.

The proposal – it will be subjected to public comment – is supported by Fed chairman Jerome Powell and the new Trump-appointed vice chair, Michelle Bowman, who said it would help build resilience in the bond market, thus reducing the risk of market dysfunction and the need for the Fed to intervene in a future stress event. Bowman, who took up the role earlier this month, is the most senior US bank regulator.

Her view is in stark contrast to that of her predecessor, Michael Barr, who said the move would reduce bank capital levels and significantly increase the risk that a G-SIB bank would fail and precipitate another crisis.

The different stances reflect the differing priorities of those engaged in the debate about bank regulation.

The proponents for lowering the leverage ratio, and also for excluding Treasury securities and bank deposits with the Fed from the calculations of leverage (which the US central bank is also considering), point to the periodic bouts of stress within the Treasury bond market. They argue that the leverage ratio has constrained the banks’ ability to support that market in times of stress by limiting their capacity to buy bonds or fund other investors’ trades.

There have been bouts of limited liquidity in the market for Treasuries, most recently after Donald Trump’s “Liberation Day” announcement of tariffs, which have forced the Fed to intervene to shore up the market.

There have been bouts of limited liquidity in the market for Treasuries, most recently after Donald Trump’s “Liberation Day” tariff blitz.Credit: Bloomberg

Some recent auctions of Treasuries have also experienced weak demand, with the Trump administration’s policies, particularly his tariffs, being blamed for what’s been described as the “Sell America” trade.

The level of demand for Treasuries is about to become even more significant. If the Republicans can agree on the final form of Trump’s One Big Beautiful Bill Act – their mega budget bill – they will add something around $US3.3 trillion to the US government’s $US36.2 trillion of debt over the next decade.

That makes the depth of demand for Treasuries critical because it will determine the prices at which the securities can be issued. The balancing item in the supply-demand equation is price, or the yield required for the market to absorb the issues.

Treasury Secretary Scott Bessent has said lowering the leverage ratio and increasing banks’ capacity to buy Treasuries could cut tens of basis points from the cost of government debt. On debt levels approaching $US40 trillion, that could mean very substantial savings.

Critics of the leverage ratio say it has kept bank balance sheets from potentially growing at the same rate as the supply of government debt, which exploded during the initial Trump administration and Joe Biden’s term in the White House.

There are at least two potential problems with looking at the leverage ratio as the solution to malfunctions within the government debt market.

One is that the cause of the problem isn’t the leverage ratio, but the rate at which the volumes of government debt have been pouring into the market – a rate that will only accelerate if the One Big Beautiful Bill Act passes.

Cut the deficits and debt, and that would alleviate the perceived problem. Instead, the proponents of deregulation want to expand the balance sheet of the banks and raise their risk profiles, so that the deficits and debt can keep mounting. Both the government and bank balance sheets would be weakened.

US Treasury Secretary Scott Bessent has said lowering the leverage ratio and increasing banks’ capacity to buy Treasuries could cut tens of basis points from the cost of government debt.Credit: AP

The second problem is that, if the regulators do free up more than $US200 billion of big bank capital, there is no certainty that the banks would use that to buy more Treasuries or prop up the market during times of stress.

They could do what their shareholders would inevitably demand and buy back that suddenly-surplus capital, with no benefit to the Treasury market at all.

The other measure being touted by the deregulation proponents, and being canvassed by the Fed, is whether Treasury securities and deposits with the Fed should be excluded from the banks’ leverage calculations.

The inclusion of supposedly “risk-free” assets, like government bonds, from leverage calculations – even though they carry zero weighting in the core capital adequacy calculations – is based on the fact that they aren’t risk-free.

As the 2008 crisis demonstrated, if America’s financial system teeters, it sends shockwaves throughout the world.

The regional bank crisis in the US in 2023 started when a run on the Silicon Valley Bank forced the lender to sell its holding of government bonds at discounts to face value – incurring significant losses – to generate liquidity to meet the calls on its deposits.

Macro events like Trump’s tariff announcements, or government inflation data, can move bond yields significantly and create paper losses that, if the bond had to be sold to raise cash, would become very real and reduce the capital levels of the bank involved.

Carving Treasuries out of the ratio might free up even more bank balance sheet capacity to buy Treasuries (or return capital to shareholders), but it would make the biggest US banks even more vulnerable to external events, and render the US system more fragile.

In Europe, that nexus between government bonds and banks was dubbed the “doom loop”, or a vicious and circular relationship between levels of government debt and banking system risk.

During the European debt crisis that followed the global financial crisis, banks hoovered up their country’s sovereign debt. As concerns about the creditworthiness of governments, particularly the over-leveraged southern European countries, mounted, the balance sheets of the banks holding piles of their government’s supposedly risk-free debt were weakened.

There’s a direct relationship between fiscal stability and financial stability.

The continuing explosion of US government debt on issue is undermining the fiscal stability of the US and increasing levels of financial system risk, even as the administration and its regulators propose weakening the levels of insurance against another banking and financial crisis.

The shape of US bank regulation matters beyond America because of the dominance of the US dollar and the US financial markets within the global financial system.

As the 2008 crisis demonstrated, if America’s financial system teeters, it sends shockwaves throughout the world. No one wants history to repeat.

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