Short-Term Rates Might Be Better Long-Term Guide on Banks’ Leverage

But that might not be the only thing to focus on. What is happening in short-term yields is also relevant. Yields on some Treasury bills this week saw their lowest closing levels since March 2020, when some bill yields closed in negative territory, according to Tradeweb. That is widely attributed to the recent drawing-down of the Treasury’s account balance at the Fed. This means more cash in the system. It also means the Treasury isn’t issuing as many new bills. The Fed has said in the past that it doesn’t want to see yields go negative, in part because it hurts banks’ profits and ability to lend. What happens with these rates will be closely watched.

Here is how this could relate to banks and leverage limits: A worry in the market is that as more cash flows into the system later this year from the Treasury and from the Fed’s quantitative easing, more-constrained banks won’t want to take customers’ deposits, instead pushing that money into vehicles such as money-market funds that buy bills.

Banks are just one part of the equation for yields, though. The Fed made a separate technical move to expand the limit per counterparty on what is known as an overnight reverse repurchase agreement. Reverse repos are designed to reduce the reserves in the banking system by selling securities to counterparties. Previously a counterparty could do up to $30 billion a day in reverse repos with the Fed; now that figure has expanded to $80 billion. This facility is often used by money-market funds. “The goal is firming the floor,” said Mark Cabana, rates strategist at Bank of America. If short-term rates don’t stabilize, other tools at the Fed’s disposal include increasing the interest rate on excess reserves or the rates for overnight reverse repos.

The Fed did say it would seek public comment on future potential modifications to big banks’ supplementary leverage ratios to ensure that the rule “remains effective in an environment of higher reserves” and to “prevent strains from developing that could both constrain economic growth and undermine financial stability.”

These tweaks might or might not help banks ultimately hold more long-term bonds. They could be more narrowly focused on banks’ ability to hold reserves. Plus, they will intersect with other measures, such as what the Fed does with global banks’ capital buffers, payout rules or stress tests. Those all affect banks’ behavior. Certainly some Senate Democrats will be on the lookout for signs of overall leniency on Wall Street, and the broader aim is for lenders to lend.

What happens to banks is just one piece of a much bigger puzzle.

Write to Telis Demos at telis.demos@wsj.com