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Because of “liquidity mismatch” (e.g., banks fund longterm, illiquid loans with deposits that can be withdrawn on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