Updates to the LCR rules: some winners, some losers

The latest incarnation of the Liquidity Coverage Ratio (LCR) rules were released. “Liquidity Coverage Ratio: Liquidity Risk Measurement Standards” clocks in at 399 pages – there is a lot minutiae of to grind though. Looking for something a little more digestible, we read a well-written Sullivan & Cromwell analysis “Basel III Liquidity Framework” (September 9, 2014) and noticed a number of interesting things.

The rules originally required daily calculations with monthly reporting. Now the largest banks will be able to calculate once a month until July 2015 and smaller banks (but large enough to be still subject to the “full LCR”) get a pass on daily calcs until July 2016. Daily number crunching is operationally difficult, but it would have made  end-of-month window dressing exercises considerably less effective. Banks got a pass, albeit short lived.

Originally the LCR rules made banks simulate open trades as an outflow that occurred on the first day of each month. US regulators had adopted a peak outflow methodology. Banks had to have enough HQLA to cover the peak outflow day for an 30-day period – a more onerous rule than Basel III prescribes. Using the first day of each month as an anticipated maturity date manipulated the peak outflow date in ways that did not much sense. From the report:

“…the Final Rule eliminates the assumption that all transactions without a specified maturity date result in an outflow on the first day of each 30-calendar-day measurement Basel III Liquidity Framework period. The Final Rule, however, includes a new calculation methodology that is designed to capture such potential mismatches but only from specific types of transactions, such as repos and reverse repos with financial sector entities, that the Agencies believe are most likely to expose covered companies to maturity mismatches within the 30-day period…”

We won’t go into the nitty gritty of how this is done; suffice to say it involves an add-on to account for open trades. The Sullivan & Cromwell analysis said:

“…The Agencies acknowledge that this add-on approach involves operational challenges and may result in covered companies being required to hold more HQLA than would be required under the Basel III LCR…”

No matter how precise a bank is in managing their inflows and outflows, LCR inflows are capped at 75% of outflows, forcing banks to hold a minimum of 25% of peak outflow in HQLA. For some banks, especially those involved in securities financing, that could be a lot of HQLA.

Fortunately, HQLA includes central bank reserves – so it sounds like all those excess reserves sitting at the Fed — $2.786 trillion versus $86.9 billion in required reserves at last count — will be included to satisfy HQLA requirements.

There was some controversy around how collateralized deposits from the public sector would be treated. Originally those deposits were included in the 30-day outflow calculation, despite being collateralized and historically stable. From comments made by The Clearing House on a February 19, 2014 post:

“…The treatment of secured deposits of U.S. municipalities and public sector entities (“PSEs”) as secured funding transactions that are subject to the requirement to calculate HQLA on an unwind basis leads to substantial and unjustified negative distortions in the HQLA calculation.  The U.S. LCR as proposed could create a strong incentive for institutions to stop offering these products for PSEs, which could cause U.S. municipalities to have substantial practical difficulties in providing critical public services to citizens, meeting payroll for public servants, and more generally paying day-to-day bills…”

The new rules exempt those deposits from being included in the outflow calculation. A big win for states and municipalities. But not all was positive for the public sector. A lot of lobbying was done to include muni paper as HQLA, but it didn’t happen. The standard for HQLA is that it is “liquid and readily-marketable.” The door was not entirely shut on municipal paper, but for the time being, it doesn’t qualify as HQLA.

In a September 4, 2014 article in American Banker, “New Liquidity Rule Will Force Big Banks to Shape Up” by Mayra Rodríguez Valladares, a well known banking expert and consultant, noted:

“…Municipalities are notorious for having unreliable and opaque financials that come out only once a year—sometimes six months to three years late. These types of securities can hardly be considered high-quality…”

Interestingly enough, the regulators responded to a comment advocating that monetization (and hence liquidity) isn’t only achieved through selling the paper. If a security has an active repo market, the argument went, it should be considered liquid. The regulators agreed.

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