Supplementary Leverage Ratio (SLR) Exemption Expiration

​Last April, Jerome Powell enacted a policy to encourage lending during the pandemic called the supplementary leverage ratio (SLR) exemption.

Banks have an SLR requirement that made them hold a certain amount of capital for every liability to ensure their risks were mitigated. This modification temporarily exempted US Treasuries and deposits (which is a bank liability to an account holder) from being counted in the SLR calculation. This exemption expires at the end of March, and Powell has given no indication whether he will extend it or not. 

The consequences of the exemption itself relate to bank lending. While households reduced their debt during the pandemic, corporations and the government drastically expanded their credit. Therefore, companies that rely on uncollateralized debt to stay afloat (mostly startup technology, biotech, oil explorers, etc.) will have to pay higher interest rates, and will thereby be hurt by allowing this exemption to expire. On the positive side, if it expires, banks are forced to maintain healthier balance sheets, and will drastically reduce the chance of a market crash. So Powell is forced to make a decision that will have market implications. 

To try to figure out what Powell will do, I created a game theory tree. There are two participants in the SLR game: the Fed and the market. Theoretically, Powell isn’t supposed to care about the government, nor the rest of the world, so we will take him at his word. It turns out this is the classic prisoner’s dilemma, except with asymmetric information.

The market has two choices:
1) Get heavily leveraged or
2) Don't get heavily leveraged.

Powell has two choices:
1) Extend SLR or
2) Don't extend SLR.

When Powell issued SLR, the market made the decision that it was permanent (hence the large rally in equities and bonds). Corporate and sovereign debt skyrocketed. As a result, growth stocks became highly leveraged, and we financed ourselves out of an oil price war. He knows what the market has done; he knows they essentially "admitted fault" in the prisoner's dilemma game. Powell's missions are full employment and inflation over 2%. Powell knows that not extending SLR gets him the latter.

Therefore, I think Powell will sacrifice the short-term market leverage bubble and let SLR go.

So, who would know this on Powell’s team? The banks!

The primary dealers take all the bonds no one else wants and receive insight into Fed deliberations. How are banks positioned? The negative repo rates shows heavy shorting of bonds, to the point of paying extra to lend them. That is very indicative of SLR going away.

I still think any dip in equities is a buy because of the massive inflation, but growth might take a big short term hit this week.

Also… Powell knows this is a big decision, and any time he’s faced with a decision like this he leaks to the press. So, tread carefully until this decision is finalized.