The Supplementary Leverage Ratio and the intermediation limits

The Supplementary Leverage Ratio (SLR), introduced in the aftermath of the 2008 financial crisis and tightened under Basel III, was designed as a non-risk-weighted capital constraint to limit the overall size of bank balance sheets. Unlike risk-weighted capital requirements, which adjust for the perceived riskiness of assets, the SLR imposes a blunt limit: a minimum ratio of Tier 1 capital to total leverage exposure, irrespective of asset riskiness. This has far-reaching implications, particularly for low-risk assets like US Treasuries and repo positions, which traditionally served as the backbone of financial intermediation.

Although it hasn't been discussed extensively, the enhanced Supplementary Leverage Ratio (eSLR) also carries significant implications. The eSLR requires the largest US banks (G-SIB or global systemically important bank) to hold additional Tier 1 capital against their total exposures, including Treasuries, limiting their ability to expand balance sheets without raising costly equity. In other words, it obligates G-SIBs to maintain an SLR of at least 5%. As government debt outpaces bank capital growth, the eSLR has become a binding constraint, restricting banks’ intermediation capacity in Treasury markets and amplifying reliance on non-bank financial institutions for liquidity provision.

For primary dealers - banks obligated to underwrite and make markets in USTs - the SLR creates a mechanical constraint on balance sheet capacity. Holding Treasuries, whether outright or as collateral in repos, consumes leverage exposure (under the SLR calculation). This disincentivizes primary dealers from expanding their balance sheets to absorb Treasury issuance, especially during periods of supply gluts or stress episodes, when balance sheet elasticity is most needed. The March 2020 dash-for-cash episode, the 2023-2024 wave of Treasury issuance, and even the events of April 2nd serve as stark reminders of this structural bottleneck. The figure below illustrates how primary dealers’ share of auction awards of longer-term US Treasuries has declined in recent years.

Source: Bank Policy Institute

Enter the prime brokers.

Prime brokers, subsidiaries of large banks but often accounting-wise and operationally distinct from the balance-sheet intensive primary dealer operations, act as liquidity providers for hedge funds. While subject to consolidated capital requirements at the group level, prime brokerage businesses operate with greater flexibility in facilitating leveraged trading strategies, notably basis trades in USTs and futures. Hedge funds, leveraging prime broker credit, have thus become pivotal players in absorbing Treasury supply and providing market liquidity, particularly through relative value trades that primary dealers are increasingly constrained from executing themselves (as we discussed three days ago).

In this sense, the SLR has contributed to a significant transformation in US Treasury market intermediation. By limiting primary dealers’ capacity to warehouse Treasuries, it has pushed intermediation into the less regulated, or at least differently constrained, sphere of hedge funds and their prime brokers. This dynamic reflects a subtle but profound shift: the effective balance sheet capacity for US Treasuries has migrated from banks’ core dealer operations to their prime brokerage clients, with the bank acting as an intermediary of last resort rather than a principal.

However, this raises a paradox. While prime brokers facilitate hedge funds' leveraged positions, their own capacity is indirectly bounded by the same SLR constraints at the consolidated bank level. In other words, a bank-affiliated prime broker is also subject to the overall regulatory requirement of its parent bank. Moreover, it is argued that constraints of prime brokers lead to lower future return, alpha, volatility, Sharpe ratio, and information ratio of the hedge funds, as quoted in here. During normal times, internal balance sheet allocations can be managed to prioritize prime brokerage activity (as we discuss about bank-affiliated prime brokers), especially given its profitability. Yet in times of stress, when aggregate balance sheet pressure rises, the constraint reasserts itself. This was evident both in March 2020 and April 2025 when prime brokers curtailed financing to hedge funds, exacerbating market dysfunction as hedge funds were forced to unwind basis trades and liquidate Treasuries.

Thus, the SLR has a dual effect: it constrains primary dealers directly and prime brokers indirectly, while simultaneously promoting a market structure where non-bank financial institutions (hedge funds) have become critical intermediaries in the UST market. This structural shift increases the system’s reliance on leverage-sensitive entities and introduces procyclical vulnerabilities. In periods of low volatility and abundant liquidity, the model appears stable; yet under stress, the latent fragility emerges, as both primary dealers and prime brokers face simultaneous balance sheet pressures and margin calls, limiting their capacity to intermediate precisely when most needed.

In short, the SLR has reconfigured the Treasury market's intermediation hierarchy - not by reducing leverage per se, but by redistributing it away from regulated bank dealer desks toward the shadow banking system via prime brokerage channels. While this satisfies the letter of regulatory intent, it introduces new systemic dependencies that policymakers are only beginning to fully grapple with.

This explains why policymakers across the political spectrum are now converging on SLR reform. Treasury Secretary Scott Bessent’s framing of the SLR as a “surcharge” on banks buying Treasuries captures the growing frustration. The argument is straightforward: government securities are “risk-free”, and their swelling volumes should not penalize bank capital ratios. By exempting Treasuries, banks - particularly primary dealers - could expand their balance sheets to absorb new issuance without raising additional capital. Estimates suggesting that abolishing the SLR could lower yields by 30-70 basis points illustrate what is at stake, both for markets, but also for fiscal sustainability.

Regulators, too, are signaling a shift. Michelle Bowman, Trump’s nominee for Fed Vice Chair of Supervision, has openly linked SLR reform to enhancing Treasury market liquidity. Even the typically cautious Jerome Powell and Michael Barr have acknowledged the need to revisit the rule.

Two main reform paths are under discussion. The first echoes the 2020 emergency measure: exclude Treasuries and reserves from the SLR denominator. This would directly incentivize banks to expand holdings of government debt without weakening overall capital requirements. The second, more structural option involves lowering the SLR’s threshold itself - from the current 5% to just above 3% - effectively recalibrating leverage requirements in line with today’s balance sheet realities.

While superficially appealing, this proposal is flawed.

First, the assumption that government securities are “risk-free” conflates credit risk with market risk. In other words, USTs may be free from credit risk, but they are not immune to market risk, particularly duration risk. While US Treasuries are unlikely to default, their market value is highly sensitive to interest rate movements. The collapse of Silicon Valley Bank (SVB) in March 2023 is the most vivid example of this fallacy. Nearly half of SVB’s assets were in government and agency securities - considered safe by conventional standards. However, as interest rates rose sharply, these securities incurred significant unrealized losses. When faced with sudden deposit outflows, SVB was forced to liquidate these assets at a loss, crystallizing what had been accounting illusions into real solvency threats. In other words, they held held-to-maturity (HTM) assets whose unrealized losses became realized once they needed liquidity and were forced to sell those assets. In essence, the presumed safety of these securities became a vector of systemic fragility.

Exempting Treasuries from the SLR would institutionalize this mispricing of risk. Banks would be incentivized to load up on duration risk, maximizing returns on equity by expanding Treasury holdings without allocating corresponding capital buffers. Yet, as SVB demonstrated, rising rates can quickly turn “safe” assets into liquidity and solvency risks. This is not merely a one-off episode but a structural vulnerability.

Second, such an exemption would exacerbate moral hazard. With no private capital backing Treasury portfolios, banks’ implicit subsidy from government guarantees would widen. The Federal Reserve’s increasingly activist role as market backstop - through standing repo facilities, emergency lending at par, and other interventions - would effectively socialize the risks while privatizing the gains.

One theoretically sound mitigation strategy could be to require banks to hedge the interest rate risk of their Treasury holdings using interest rate swaps (IRS). SVB also entered into swaps but prematurely exited these positions in late 2022, so before Fed tightened its monetary policy (why? to increase their revenue). By paying fixed and receiving floating, banks could neutralize the duration risk of their Treasury portfolios. In principle, this would prevent mark-to-market losses when yields rise (at a local level, e.g. in the bank’s balance sheet), stabilizing the value of these positions even under adverse rate environments.

However, this strategy does not address the root issue: the sheer scale of government debt relative to the financial sector's intermediation capacity. Hedging mitigates interest rate risk, but it does not alleviate leverage constraints. The SLR would still cap banks' ability to expand their balance sheets, irrespective of the hedged status of their positions.

Under these conditions, a pragmatic solution would be to abandon the strictly non-risk-weighted nature of the SLR and modify the leverage ratio framework to apply differentiated treatment for risk-free assets - such as assigning a lower, but never zero, weighting to Treasuries compared to private-sector assets. This approach would mitigate the moral hazard that would arise from a 0% weighting, while transforming the SLR into a hybrid leverage-risk-based measure. Such a recalibration would provide banks with greater balance sheet flexibility without compromising systemic safeguards. In periods of market stress, the logical next step to further contain systemic risk would be to strengthen the interaction between hedge funds and the Federal Reserve’s balance sheet, ensuring liquidity provision through secured channels.