Should Commercial Banks Be Shadow Central Banks?
In a recent article the Bank Policy Institute noted that the U.S. Treasury market faces increasing intermediation challenges that could threaten its stability and resilience. Over the past two decades, the article explains, the federal debt has increased dramatically relative to the balance sheets of the largest banks. For example, Treasury securities as a percentage of bank assets increased from 3 percent in 2013 to 11 percent in 2024. The article further states that banks face difficulties in increasing their Treasury debt holdings due to the requirement that they fund all their assets with a minimum amount of investor capital—the minimum leverage ratio. As a result, to finance the growing national debt while continuing to lend to an expanding private sector, banks must choose either retain more earnings to meet minimum capital requirements or redirect capital from private-sector lending to government securities—creating a crowding out effect. To prevent this, the post goes on to suggest exempting Treasury balances from inclusion in the minimum leverage ratio requirement. This change would allow commercial banks to continue making loans while holding Treasury securities in nearly unlimited amounts. However, the suggestion overlooks some important, less desirable consequences.
We all know that banks lend to corporations, individuals and the federal government, earning a rate of interest commensurate with the perceived risk of the loan. The private sector will borrow bank funds only as long as the cost of the funds is lower than the expected returns from their use. In contrast, the government has no such constraint: While it may complain about higher rates, it will borrow whatever is necessary to cover the gap between its spending and tax revenues.
In particular, the largest banks are eligible to serve as primary dealers, intermediating trades in the Treasury securities market and holding Treasury balances until they can match buyers and sellers. Normally this is a routine process. However, government debt has grown substantially faster than the overall size of the dealers’ balance sheets, requiring them to retain proportionately more capital to accommodate the increasing volume of government securities while still meeting the minimum leverage ratio standard. Allocating more capital for the purpose of holding additional government securities might reduce these banks’ return on investor equity.
To avoid this outcome, the article proposes applying the leverage ratio only to private-sector assets while exempting government securities from the requirement. The rationale for this change is the incorrect assumption that government securities pose no risk to the banking industry and therefore require no investor capital to absorb unexpected losses. This convenient policy shift would allow the industry to finance ever-larger amounts of government debt without adding capital. As the government spends the borrowed funds, much of it would return to the banks as deposits, available for re-lending. The effect would be similar to the Federal Reserve’s quantitative easing (QE) program, expanding the money supply and inevitably causing higher inflation.[1] And there are other notable consequences.
The purpose of capital requirements is to enable banks to absorb unexpected losses, whether from funding private or public debt. While we are used to the claim that U.S. government securities are risk free, this is not entirely accurate. As interest rates rise, securities held by banks at lower rates lose value. Additionally, while accounting rules may not require these losses to be recognized unless the securities are sold, the threat of loss significantly increases the industry’s risk profile in two important ways.
First, the securities would no longer be a source of bank liquidity since they could not be sold without incurring losses, making it difficult for banks to meet unexpected deposit withdrawals. Second, if it turns out banks are forced to sell such securities and the losses are substantial, the bank could become insolvent. Such outcomes were demonstrated by the failure of Silicon Valley Bank in March 2023. Although nearly 50 percent of the bank’s assets consisted of “risk-free” government and government-guaranteed securities, when interest rates were forced to rise, the bank incurred significant unrealized losses in its securities portfolio. Subsequently, as it was forced to sell securities to meet deposit withdrawals, these losses suddenly became realized, leading to its insolvency and closure. Thus, there is no justification for exempting government securities from established minimum capital requirements, as they are not immune to losing value.
A second consequence is increased moral hazard. With no private capital behind a bank’s Treasury portfolio, bank funding and bailouts subsidies increase, exacerbating the moral hazard problem. With each new crisis, the Federal Reserve has expanded its lender of last resort role to greater purpose. For example, it recently created a standing Treasury repo facility to assure the smooth functioning of this market, making the Federal Reserve the primary source of liquidity. Additionally, following the Silicon Valley Bank failure, the Federal Reserve agreed to loan funds to banks at the securities’ par value, even though they were trading at a significant discount—essentially engaging in unsecured lending. Thus, as the banks have taken on an increasingly prominent role in the securities market, the Federal Reserve is becoming the ultimate liquidity backstop (always ready to buy or lend) to assure a “well-functioning” securities market. Banks would being shielded from the risk of capital losses when they act as intermediaries for government securities. Such assurance can only lead to banks’ taking on even greater interest rate and maturity risks to maximize earnings. The banks would accept increasing amounts of debt from one government agency, despite increasing risk, while receiving a guaranteed liquidity backstop from another: the Federal Reserve Board.
Modifying the minimum leverage ratio to exclude government securities transforms the leverage ratio into a risk-weighted capital measure that favors one type of asset over all others, leading to resource misallocation and incentivizing greater government spending, ultimately increasing inflation for future generations to bear. While The Bank Policy Institute correctly notes that the U.S. has increased spending and incurred ever-larger amounts of debt, the correct solution is not to crowd out the private sector or turn the largest banks into shadow central banks but rather to curb the massive growth of U.S. debt.
[1] The Federal Reserve could engage in reverse repo transactions to sterilize deposit growth, but it would have to maintain a large inventory of government securities to create the repos.