Fed Proposes Amended Bank Liquidity Rules

Andrew R. Gladin is a partner in the Financial Services and Corporate and Finance Groups at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell publication authored by Mr. Gladin, Samuel R. Woodall III, Andrea R. Tokheim, and Lauren A. Wansor.

On Thursday, May 21, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a notice of proposed rulemaking (the “Proposal”) that would amend the final rule implementing a liquidity coverage ratio (“LCR”) requirement (the “Final LCR Rule”), [1] jointly adopted last September by the Federal Reserve, the Office of the Comptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”), to treat certain general obligation state and municipal bonds as high-quality liquid assets (“HQLA”). [2] Unlike the Final Rule, the OCC and FDIC did not join the Federal Reserve in issuing the Proposal. Accordingly, the Proposal would apply only to banking institutions regulated by the Federal Reserve that are subject to the LCR, absent further action by the other agencies. [3] The Proposal would allow these entities to treat general obligation securities of a public sector entity (“PSE”) as level 2B liquid assets, provided that the securities generally satisfy the same criteria as corporate debt securities that are classified as level 2B liquid assets, as well as certain other restrictions and limitations applicable only to these assets as described further below. Comments on the Proposal are due by July 24, 2015.

Although the agencies originally declined to include U.S. municipal securities as HQLA in the Final Rule, expressing concern that banking institutions would be limited in their ability to rapidly monetize municipal securities during a period of significant stress, the Federal Reserve at the time indicated a willingness to continue to study the question. In support of the Proposal, the Federal Reserve cites commenters’ contentions that some U.S. municipal securities trade more often and in greater volumes than some corporate debt included as HQLA and that exclusion of U.S. municipal securities from HQLA could lead to higher funding costs for U.S. municipalities, negatively impacting local economies and infrastructure. If the other banking agencies choose not to modify the HQLA treatment of municipal securities held by entities subject to their supervision—that is, national banks and certain state chartered banks—it could substantially limit the practical usefulness of the Proposal for banking organizations, particularly those that principally hold municipal securities in their national bank subsidiaries.

The Final LCR Rule requires large banking organizations to hold HQLA that can be easily and quickly converted into cash within 30 days during a period of financial stress. The LCR divides HQLA into three categories of assets: level 1, level 2A and level 2B liquid assets. Level 1 assets are considered to be the highest quality and most liquid assets, whereas level 2B assets are considered less liquid and are therefore subject to quantitative limitations on inclusion in the stock of HQLA.

The Proposal would allow Federal Reserve-regulated institutions to include as level 2B liquid assets U.S. municipal securities that meet the following criteria:

  • General obligation of the PSE. U.S. municipal securities must be the general obligations and be backed by the full faith and credit of the issuing PSE. Under the Proposal, revenue obligations, meaning obligations where the PSEs have committed to repay with revenues from a specific project rather than from general tax funds, would not qualify as HQLA.
  • Investment grade. U.S. general obligation municipal securities must be “investment grade” as of the calculation date, consistent with the requirements for corporate debt securities that are included as level 2B liquid assets.
  • Issued by PSE with proven record as a reliable source of liquidity. Securities must be issued by an entity whose obligations have a proven record as a reliable source of liquidity in repurchase or sale markets during a period of significant stress. Banking institutions must demonstrate this record of liquid reliability by showing that the market price of the U.S. general obligation municipal securities or equivalent securities of the issuer declined by no more than 20 percent during a 30 calendar-day period of significant stress, or that the market haircut demanded by counterparties to secured lending and secured funding transactions that were collateralized by such debt securities or equivalent securities of the issuer increased by no more than 20 percentage points during a 30 calendar-day period of significant stress. To support their conclusions, banking institutions may reference the historical market prices and available funding haircuts of the U.S. general obligation municipal security during periods of significant stress, such as the 2007-2009 crisis, as well as other periods of systemic and idiosyncratic stress.
  • Not an obligation of a Financial Sector Entity or its consolidated subsidiaries. Municipal securities cannot be issued or guaranteed by a financial sector entity or a consolidated subsidiary of a financial sector entity. In effect, this would typically preclude the inclusion of municipal securities that are guaranteed or “wrapped” by a bond insurer in HQLA.

The Proposal also places further limitations on the amount of U.S. general obligation municipal securities that a banking institution could include as eligible HQLA as follows:

  • Limitation on the inclusion of U.S. general obligation municipal securities with the same CUSIP number as eligible collateral. Securities may be included as HQLA only to the extent the fair value of the institutions’ securities with the same CUSIP number do not exceed a maximum of 25 percent of the total amount of outstanding securities with the same CUSIP number. This threshold for inclusion would be calculated prior to application of the 50 percent haircut applicable to level 2B liquid assets. This limitation reflects the Federal Reserve’s concern that banking institutions may not be able to monetize a concentration in the holding of a particular issuance of U.S. general obligation municipal securities during a period of significant stress without a material impact on the securities’ price, especially in light of the generally smaller but more numerous issuances of PSEs as compared to issuances by corporate issuers.
  • Limitation on the inclusion of the U.S. general obligation municipal securities of a single issuer as eligible HQLA. The Proposal would limit the aggregate fair value of U.S. municipal securities that a banking institution could include as HQLA of a particular PSE to two times the average daily trading volume, as measured over the previous four quarters, of all general obligation municipal securities issued by that PSE.
  • Limitation on the amount of U.S. general obligation municipal securities that can be Included in the HQLA amount. The Proposal would limit the amount of U.S. general obligation municipal securities included in HQLA to no more than five percent of a banking institution’s total HQLA amount. This limit is in addition to the 40 percent limit on the aggregate amount of level 2A and level 2B liquid assets and the 15 percent limit on level 2B liquid assets that can be included in the HQLA amount already built into the LCR.

Like other HQLA, U.S. general obligation municipal securities held by a subsidiary would be subject to restrictions on inclusion in a parent banking organization’s HQLA. [4]

The Proposal poses several questions for comment, including:

  • How should the Federal Reserve supplement or amend the proposed criteria for including U.S. general obligation municipal securities as HQLA?
  • Is it appropriate to exclude U.S. general obligation municipal securities that are wrapped by bond insurers or other financial sector entities from HQLA because of wrong-way risk?
  • What additional alternative limitations should the Federal Reserve consider relating to the inclusion of individual and aggregate issuances of U.S. public sector entities as eligible HQLA?
  • How else could the Federal Reserve address concerns regarding concentrations and minimizing market price movements associated with sales of HQLA?

Endnotes:

[1] 12 CFR Part 249. For additional information regarding the LCR, please see our memorandum to clients, Basel III Liquidity Framework: Federal Reserve Approves Final Rule Implementing Basel III Liquidity Coverage Ratio for Large U.S. Banks (September 9, 2014), available at http://www.sullcrom.com/basel-iii-liquidity-framework-federal-reserve-approves-final-rule-implementing-basel-iii-liquidity-coverage-ratio-for-large-us-banks.
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[2] Liquidity Coverage Ratio: Treatment of U.S. Municipal Securities as High-Quality Liquid Assets (May 21, 2015).
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[3] Federal Reserve-regulated banking institutions subject to the LCR include: (i) bank holding companies, certain savings and loan holding companies, and state member banks that, in each case, have $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure; (ii) state member banks with $10 billion or more in total consolidated assets that are consolidated subsidiaries of bank holding companies described in (i); and (iii) nonbank financial companies designated by the Financial Stability Oversight Council for Federal Reserve supervision to which the Federal Reserve has applied the LCR by rule or order.
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[4] For U.S. consolidated subsidiaries that are depository institutions subject to the LCR, a banking institution may include the consolidated subsidiary’s assets in its HQLA in an amount up to the consolidated subsidiary’s net cash outflows plus any amount that would be available for transfer to the top-tier company “during times of stress without statutory, regulatory, contractual, or supervisory restrictions, including sections 23A and 23B of the Federal Reserve Act.” 12 CFR 249.22(b)(3)(i). For U.S. consolidated subsidiaries that are not subject to the LCR, the covered company may include the amount of net cash outflows of the consolidated subsidiary as of the 30th calendar day after the calculation date, as calculated by the banking organization for the banking organization’s minimum liquidity standard, plus any amount that would be available for transfer to the top-tier company during times of stress without restrictions. 12 CFR 249.22(b)(3)(ii).
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