The Federal Reserve came out with their LCR proposals today. Comments on the 100 page plus document are due back by January 31, 2014. We took a look and have some observations.
Who is impacted? From the rule making:
“…The proposed rule would apply to all internationally active banking organizations, generally, bank holding companies, certain savings and loan holding companies, and depository institutions with more than $250 billion in total assets or more than $10 billion in on-balance sheet foreign exposure, and to their consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets. The proposed rule would also apply to companies designated for supervision by the Board by the Financial Stability Oversight Council under section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5323) that do not have significant insurance operations and to their consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets…”
The underlying theme is
“…Beginning in January 2015, under the Basel III LCR, internationally active banking organizations would be required to hold sufficient high-quality liquid assets (HQLA) to meet their obligations and other liquidity needs that are forecasted to occur during a 30-calendar day stress scenario. To meet the Basel III LCR standard, the HQLA must be unencumbered by liens and other restrictions on transferability and must be convertible into cash easily and immediately in deep, active private markets…”
What is the timing of compliance?
“…Under the proposed rule’s transition provisions, covered companies would be required to comply with a minimum liquidity coverage ratio of 80 percent as of January 1, 2015. From January 1, 2016, through December 31, 2016, the minimum liquidity coverage ratio would be 90 percent. Beginning on January 1, 2017 and thereafter, all covered companies would be required to maintain a liquidity coverage ratio of 100 percent…”
This is faster that the January 2013 BIS rules which were 60% compliance by January 2015, rising 10% per year until full compliance by January 2019.
What does the mix of HQLA look like?
“…Consistent with the Basel III LCR, the agencies are proposing to divide HQLA into three categories of assets: level 1, level 2A and level 2B liquid assets. Specifically and as described in greater detail below, the agencies are proposing that level 1 liquid assets, which are the highest quality and most liquid assets, be included in a covered company’s HQLA amount without a limit. Level 2A and 2B liquid assets have characteristics that are associated with being relatively stable and significant sources of liquidity, but not to the same degree as level 1 liquid assets. Accordingly, level 2A liquid assets would be subject to a 15 percent haircut and, when combined with level 2B liquid assets, could not exceed 40 percent of the total stock of HQLA. Level 2B liquid assets, which are associated with a lesser degree of liquidity and more volatility than level 2A liquid assets, would be subject to a 50 percent haircut and could not exceed 15 percent of the total stock of HQLA…”
In the BIS rules, certain level 2B RMBS assets are subject to a 25% haircut while permitted investment grade corporate debt and common equity is subject to a 50% haircut. It looks like the Fed painted all 2B assets with a 50% haircut brush.
Central Bank Reserves:
“…Under the BCBS LCR framework, “central bank reserves” are included in HQLA…Under the proposed rule, all balances a depository institution maintains at a Federal Reserve Bank…would be considered level 1 liquid assets…”
In other words, excess reserves held at the Fed are included. Given the enormous amount of excess reserves sitting at the Fed, we wonder if for many banks LCR could be substantially mitigated. As long as IOER rates are above short term Treasuries (these days you have to go past 1 year for returns to top 25bp), this will create further incentive to keep short-term liquidity at the Fed. The dynamic will change as and when the Fed’s SOMA assets run down or are sold (a/k/a “taper”) and excess reserves are removed from the system. But that is looking like it will take a while.
Looking at 2B eligible assets:
“…A covered company would be required to demonstrate this record of liquidity reliability and lower volatility during times of stress by showing that the market price of the publicly traded debt securities or equivalent securities of the issuer declined by no more than 20 percent or 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-day stress period…”
This is an interesting rule. Banks will have to look at how a similar asset behaved during a stress period (read: post-Lehman). If the paper dropped 20 points or the repo haircut went up by more than 20 points, it is ineligible. Looking at the price history can be challenging, but data should be available. But looking at repo haircuts, that is another story. There is hardly any historical data on bilateral repos available, much less issuer specific haircuts. We know that tri-party haircuts during the crisis were sticky and not much of an indicator of anything.
Assets held as a hedge:
“…If an HQLA were being used to hedge a specific transaction, such as holding an asset to hedge a call option that the covered company had written, it could not be included in the HQLA amount because its sale would conflict with another business or risk management strategy. However, if HQLA were being used as a general macro hedge, such as interest rate risk of the covered company’s portfolio, it could still be included in the HQLA amount…”
Operationally this could be complicated.
How is net outflow calculated?
“… the total net cash outflow amount would be the dollar amount on the day within a 30-day stress period that has the highest amount of net cumulative cash outflows. The agencies believe that using the largest daily calculation as the denominator of the liquidity coverage ratio (rather than using total cash outflows over a 30-day stress period, which is the method employed by the Basel III LCR) is necessary because it takes into account potential maturity mismatches between a covered company’s outflows and inflows, that is, the risk that a covered company could have a substantial amount of contractual inflows late in a 30-day stress period while also having substantial outflows early in the same period. Such mismatches could threaten the liquidity of the organization. By requiring the recognition of the highest net cumulative outflow day of a particular 30-day stress period, the agencies believe that the proposed liquidity coverage ratio would better capture a covered company’s liquidity risk and help foster more sound liquidity management…”
This is a change versus the Basel III formula. It will prevent some gaming of the LCR. Looking at the peak net cumulative outflow over a rolling 30 day period and making sure HQLA covers that full amount is a tougher standard than the original Basel III rules.
Impact of changes in financial condition:
“…Accordingly, the proposed rule would require a covered company to count as an outflow 100 percent of all additional amounts that the covered company would need to post or fund as additional collateral under a contract as a result of a change in its financial condition. A covered company would calculate this outflow amount by evaluating the terms of such contracts and calculating any incremental additional collateral or higher quality collateral that would need to be posted as a result of the triggering of clauses tied to a ratings downgrade or similar event, or change in the covered company’s financial condition. If multiple methods of meeting the requirement for additional collateral are available (i.e., providing more collateral of the same type or replacing existing collateral with higher quality collateral) the banks may use the lower calculated outflow amount in its calculation…”
This could also be difficult to calculate. CCPs can increase collateral requirements as a result of market and counterparty stress (remember MF Global and LCH?). What are the limits on how much more a clearinghouse can ask for? On bilateral trades an agreement (e.g. a CSA) will govern additional collateral requirements.
We are sure that dozens of lawyers will spend the next couple days sifting through this document and we’ll get a better feel for how banks will (or won’t) be impacted.
A link to the Fed proposed rulemaking is here.
A link to the Fed’s press release is here.
A link to “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” (January, 2013) rules on LCR is here.