Financial Reform: Muni Bonds and the LCR

Financial Reform: Muni Bonds and the LCR

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January 10, 2018
Financial Reform: Muni Bonds and the LCR
This In Focus reviews legislative proposals to require
enterprises (GSEs), certain investment-grade corporate debt
regulators to allow large banks to use municipal (muni)
securities, and equities in the Russell 1000 Index.
bonds to meet the requirements of the Liquidity Coverage
Ratio (LCR). Municipal bonds are debt securities issued by
Different types of assets are relatively more or less liquid.
state and local governments or public entities to finance
In the LCR, assets eligible as HQLA are assigned to one of
government spending and public activities. Certain bank
three categories (Levels 1, 2A, and 2B). Assets assigned to
regulators do not allow them to be used to meet the LCR,
the most liquid category (Level 1) receive more credit
which may act as a disincentive for large banks to hold
toward meeting the requirements, and assets in the least
them compared to eligible assets. Whether municipal bonds
liquid category (Level 2B) receive less credit (see Table 1).
are liquid enough to qualify under the LCR is a contentious
For example, 50% of the value of a Level 2B asset counts
issue, with possible implications for financial stability and
toward the HQLA, and Level 2B assets can make up 15%
the ability of states and localities to raise funds.
of total HQLA, at most.
Liquidity Coverage Ratio
Table 1. HQLA Requirements
Because of “liquidity mismatch” (e.g., banks fund long-
term, illiquid loans with deposits that can be withdrawn on
% of Asset Value
demand), banks are inherently prone to liquidity crises—a
Counting
Max % of Total
temporary loss of access to funding can cause an otherwise
Asset Level
Toward HQLA
HQLA
healthy bank to fail. In response to acute liquidity shortages
Level 1
100%
100%
and asset “fire sales” during the 2007-2009 financial crisis,
the banking regulators—the Federal Reserve (Fed), Office
Level 2A
85%
n/a
of the Comptroller of the Currency (OCC), and Federal
Level 2B
50%
15%
Deposit Insurance Corporation (FDIC)—issued a final rule
in 2014 implementing the LCR. The LCR is part of bank
Level 2A+2B
n/a
40%
liquidity standards required for large banks by Basel III
Source: CRS based on Liquidity Coverage Ratio rule.
(internationally negotiated bank regulatory standards) and
the Dodd-Frank Act (P.L. 111-203). The LCR aims to
Municipal Bonds in the LCR. The Fed currently allows
reduce the liquidity mismatch by requiring banks to hold
the depository institutions and holding companies it
more liquid assets.
regulates to count a limited amount of municipal securities
as Level 2B assets. The FDIC and OCC do not allow the
The LCR applies to two sets of banks. A more stringent
depositories they regulate to count municipal securities as
version applies to the largest, internationally active banks—
HQLAs. As a result, many banks subject to the LCR must
those with at least $250 billion in assets and $10 billion in
comply with the Fed’s version of the LCR at the holding
on-balance-sheet foreign exposure. A less stringent version
company level and the OCC/FDIC’s version of the rule at
applies to depositories with $50 billion to $250 billion in
the depository subsidiary level.
assets, except for those with significant insurance or
commercial operations. As of 2017, over 30 institutions
In the 2014 final joint rule, municipal bonds did not qualify
must comply with the LCR. At this time, the rule does not
as HQLA to meet the LCR. However, a subsequent 2016
apply to credit unions, community banks, foreign banks
final rule issued only by the Fed changed its treatment of
operating in the United States, or nonbank financial firms.
municipal securities. According to the Fed,
The LCR requires banks to hold enough “high-quality
liquid assets” (HQLA) to
The final rule allows investment-grade, U.S.
be able to meet possible net cash
general obligation state and municipal securities to
outflows over 30 days in a hypothetical market stress
scenario in which creditors are withdrawing substantial
be counted as HQLA up to certain levels if they
amounts of funds. An asset can qualify as a HQLA if it is
meet the same liquidity criteria that currently apply
(1) less risky, (2) has a high likelihood of remaining liquid
to corporate debt securities. The limits on the
during a crisis, (3) is actively traded in secondary markets,
amount of a state’s or municipality’s securities that
(4) is not subject to excessive price volatility, (5) can be
could qualify are based on the liquidity
easily valued, and (6) is accepted by the Fed as collateral
characteristics of the securities.
for loans. The assets that regulators have approved as
In the Fed’s rule, the amount of municipal debt eligible to
HQLA include bank reserves, U.S. Treasury securities,
be included as HQLA is subject to various limitations,
certain securities issued by foreign governments and
including an overall cap of 5% of a bank’s total HQLA. The
companies, securities issued by U.S. government-sponsored
Fed requires banks to demonstrate that a security has “a
proven record as a reliable source of liquidity in repurchase
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link to page 2 Financial Reform: Muni Bonds and the LCR
or sales markets during a period of significant stress” in
excluding 95 percent of the market strikes the right
order for it to qualify as HQLA.
balance.
Legislative Proposals
Thus, proponents of the legislation argue that the Fed’s rule
H.R. 1624, as passed by the House on a voice vote on
has not significantly mitigated the perceived impact of the
October 3, 2017, would require any municipal bond “that is
LCR on municipal financing. However, under the
both liquid and readily marketable and investment grade” to
legislation, the bank regulators would still be responsible
be treated as no lower than a Level 2B HQLA for purposes
for determining which bonds qualify, under the same
of complying with the LCR.
criteria currently used by the Fed. Therefore, the number of
municipal bonds eligible to be HQLA would increase (from
Section 403 of S. 2155, which was reported by the Senate
zero) for OCC- and FDIC-regulated institutions, but would
Banking, Housing, and Urban Affairs Committee on
not necessarily change for Fed-regulated institutions.
December 18, 2017, would require any municipal bond
“
Table 2. Municipal Holdings at BHCs Subject to LCR
that is both liquid and readily marketable and investment
grade” to be treated as a Level 2B HQLA for purposes of
% Increase Since
complying with the LCR.
Currently
2017 Q3
2013:Q4 (pre-LCR)
Both bills would effectively require the OCC and FDIC to
BHCs over $50B
$187 bil ion
30%
bring the status of municipal bonds under the LCR in line
with the Fed’s current treatment. Under
BHCs facing
$162 bil ion
25%
S. 2155, municipal
stricter LCR
bonds could be treated only as Level 2B assets, whereas
H.R. 1624 leaves open the possibility of regulators
Source: CRS calculation using Federal Reserve Y9-C data.
choosing to give them a more favorable status (as they
Notes: Reported fair value of securities issued by states and political
could currently choose to do).
subdivisions in the United States. The percentage increase from 2013
is only for banks that reported data in 2013. Eight BHCs subject to
Analysis
the LCR did not report data in 2013.
Some Members of Congress supporting this legislation
have voiced concern about the LCR’s impact on the ability
Bank Liquidity. The LCR is meant to ensure that banks
of states and local governments to borrow money. The
have ample assets that can be easily liquidated in a stress
legislation could also have an effect on bank profitability
scenario. Some argue that municipal bonds should qualify
and riskiness. Because large banks’ holdings of municipal
as HQLA because most pose little default risk, but this
bonds are limited and the Fed already treats them as Level
confuses default risk, which is addressed by bank capital
2B HQLA, the effect of the proposal on both is likely to be
requirements, with liquidity risk, which is addressed by the
limited.
LCR. A municipal bond may pose little default risk, but
nevertheless be illiquid (i.e., hard to sell quickly).
Municipal Finance. To the extent that the LCR reduces the
demand for banks to hold municipal securities, it would be
Proponents of including municipal debt as HQLA claim
expected to increase the borrowing costs of states and
that some municipal securities are more liquid than some
municipalities. The impact of the LCR on the municipal
assets that currently qualify as HQLA, such as corporate
bond market is limited by the fact that relatively few banks
debt. However, for purposes of the LCR, frequent trading
are subject to the LCR. In addition, even banks subject to
may not be the only relevant characteristic of HQLA. For
the LCR are still allowed to hold municipal bonds, as long
example, regulators argue that one reason why municipal
as they have a stable funding source to back their holdings.
bonds should not qualify as HQLA is because banks cannot
easily use them as collateral to access liquidity from repo
Some data indicate that the LCR may not have had a
(repurchase agreement) markets.
substantive impact on municipal finance. As shown in
Table 2, banks subject to the LCR reported $187 billion of
Some municipal securities are liquid in the sense that they
municipal bond holdings in the third quarter of 2017,
are frequently traded, whereas others are not. According to
compared with total outstanding municipal debt of $3.8
data from the Municipal Securities Rulemaking Board, the
trillion. (The subset of these banks that must meet the
50 most actively traded municipal bond CUSIP (Committee
stricter version of the LCR holds $162 billion.) Further, the
on Uniform Securities Identification Procedures) numbers
value of these holdings has grown by 30% since the LCR
traded at least 1,972 times per year each, but even some of
was implemented for banks that reported holdings in 2013.
the largest value CUSIPs traded less than 100 times each in
2016.
In its final rule, the Fed did not provide an estimate of how
many municipal bonds would qualify as HQLA. According
CRS Resources
to an estimate of the proposed rule by the Securities
CRS In Focus IF10208, The Liquidity Coverage Ratio and
Industry and Financial Markets Association,
the Net Stable Funding Ratio, by Marc Labonte.
By one calculation, only $186 billion of the nearly
Marc Labonte, Specialist in Macroeconomic Policy
$3.7 trillion of outstanding bonds would be eligible
David W. Perkins, Analyst in Macroeconomic Policy
to be included as HQLA…. we do not believe that
IF10804
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Financial Reform: Muni Bonds and the LCR

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https://crsreports.congress.gov | IF10804 · VERSION 2 · NEW