1
$\begingroup$

As several major banks disclosed their financial reports recently, there seems to be much interest in the financial community as to the implications of the large cash piles at US commercial banks. The issue appears to stem from the Fed interventions, which added liquidity to the market but also led to a large accumulation of deposits at commercial banks. In the cases of JP Morgan and BofA, the cash piles are in the hundreds of billions of dollars.

One view is that if demand for loans remains weak and deposits continue to grow, cash piles will increase. If the cash piles increase enough then Dodd-Frank/Basel regulations come into effect, imposing stricter capital requirements. From a business standpoint, this would be a negative for the affected US banks.

I can follow this line of logic, but I feel as though I'm missing something.

Question

Surely, if a commercial bank has a larger cash pile, its capital adequacy is improved? If the cash comes from the Fed, that would not change things; the Fed would just be improving the banks' capital strength for them?

$\endgroup$
1
  • 1
    $\begingroup$ "Cash pile" needs to be defined in terms of assets of the bank sector in the bank liquidity cushion or in terms of liabilities of the bank sector held as assets in the non-bank sector liquidity cushion. In general "flight to safety" means both banks and non-banks in aggregate want to hold more risk free assets in their respective liquidity cushions and fewer risk assets in their portfolios. Covid shock to real economy triggers "run" away from bank liabilities at risk so banks either sell high quality liquid assets (HQLA) to keep cash flowing or Fed/Treasury provide liquidity to the system. $\endgroup$ Jan 22 at 2:36
2
$\begingroup$

The regulation that you are referring to is part of Basel III's Capital requirements. I believe the most relevant regulation is the Supplementary Leverage Ratio. In short, the SLR is a ratio of core capital in the numerator and assets (or exposures) in the denominator.

$$ \text{SLR} = \frac{\text{Capital}}{\text{Exposures}} $$

The measure of capital used is Basel III's Common Equity Tier 1 (CET1) measure. This is supposed to measure permanent, fully loss absorbing capital---the safest form of capital. This does not include cash held against deposits. However, these deposits do count in the demoninator. Thus, new deposits serve to bring the SLR down. The regulation adopted in the US requires that the SLR be above 3%, and potentially higher depending on the institution. For example, "the U.S. regulatory minimum SLR for global systemically important banks (GSIBs) is 5%, however, U.S. GSIBs generally run an SLR north of 6% in order to be considered 'well-capitalized'" (See here.)

Thus, the abundance of cash is bringing down the SLR of banks. If it gets to low, they may be subject to fines. They could try to raise additional capital, but this capital would be more expensive than it's worth, since the banks have been unable to issue loans or find other ways to dispose of the excess cash.

References and Background

  • Supplementary Leverage Ratio. One rule is the “supplementary leverage ratio” (SLR), which requires big banks to fund themselves with equity worth at least 5% of their total assets.

  • Supplementary Leverage Ratio varies by institution. The supplementary leverage ratio generally applies to financial institutions with more than $250 billion in total consolidated assets. It requires them to hold a minimum ratio of 3 percent, measured against their total leverage exposure, with more stringent requirements for the largest and most systemic financial institutions.

  • Banks to Companies: No More Deposits, Please "Top of mind for many big banks is a rule requiring them to hold capital equivalent to at least 3% of all assets. Worried about the rule’s impact during the pandemic, the Fed changed the calculation in 2020 to ignore deposits the banks held at the central bank, but ended that break this March. Since then, some banks have warned the growing deposits could force them to raise more capital, or say no to deposits."

  • What can banks do to raise their SLR? “By then, however, banks will have adjusted to the new regime as they have a few options to consider. Banks could:

    • increase tier 1 capital (numerator) by issuing preferred or common stock,
    • reduce their leverage exposure (denominator) by selling treasuries, decreasing deposits (pushing savers out of holding deposits and into money market funds) or,
    • decrease their market making/repo activity (off-balance sheet activity).”
$\endgroup$
1
  • 1
    $\begingroup$ Great answer! Finally get it now $\endgroup$ Sep 22 at 2:35

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.