How Regulators Toughened New Liquidity Proposal

WASHINGTON — Regulators unveiled a proposal Thursday that would institute tough new liquidity requirements on U.S. financial institutions, acknowledging that their plan is more "stringent" than a global framework suggested by international supervisors.

"The proposed Liquidity Coverage Ratio we review today is 'super-equivalent' to the Basel Committee's LCR standard," said Federal Reserve Board Gov. Daniel Tarullo during an open board meeting.

The first-time liquidity rule, jointly written by the Fed, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, is designed to ensure banks hold enough liquidity to withstand a prolonged market crisis.

In January, global regulators agreed to amend their initial proposal to expand the types of "highly liquid" assets and allow banks more time to build up their buffer.

But U.S. regulators opted to strengthen the global proposal further in a few key areas, choosing to tighten the definition of highly liquid asset, hasten the transition timeline, and ensuring the treatment of maturity mismatch in the 30-day window.

The move was expected, given how regulators have implemented other parts of the international framework agreed upon by the Basel Committee on Banking Supervision.

"It's consistent with what they've been doing on the capital rules," said Michael Bleier, partner in the Financial Services Regulatory practice at Reed Smith LLP and former general counsel at Mellon Bank. "They want to set the ground rules."

But given the landmark effort, U.S. regulators tried to signal they would maintain some flexibility in how they implement the rule, especially in regards to cases where a bank may fall below the LCR requirement.

"Because of the myriad of liquidity stresses that a covered company or modified LCR company may experience, the proposal would give supervisors flexibility in responding to instances in which a company's liquidity coverage ratio falls below the minimum LCR requirement," according to a staff memo.

Rather than hard wire a reaction into the rule, regulators agreed in 2010 to issue interagency guidance that would address issues of contingency planning by U.S. financial institutions in the event they are below the minimum.

Regulators opted to speed up the transition time in light of the fact that U.S. financial institutions had substantially improved their liquidity position since the 2008 financial crisis. Although the majority of U.S. banks that would have to comply with the rule already meet or exceed the requirement, Fed officials said there remains a roughly $200 billion shortfall.

The banking agencies also adjusted the definition of high-quality assets. While they stuck to the three categories of assets suggested by global supervisors, they excluded some assets including covered bonds, mortgage-backed private-label securities and municipals given their relative lack of liquidity.

Wayne Abernathy, executive vice president for financial institutions policy and regulatory affairs at the American Bankers Association, called the move "disappointing," arguing it was "dangerous to narrow the field" of potential assets a bank can rely on since the source of stress can vary greatly.

"You want to make sure you avoid narrowing your potential field of liquid assets by too much or else create a systemic risk in of itself," said Abernathy.

Regulators also provided for a more tailored approach in its application of the proposal, given the pushback it received under capital rules.

For example, firms that have less than $50 billion in assets would be exempted from the rule, while institutions that have $250 billion or more in assets or have substantial international operations would be subject to the full proposal. Other firms in the "middle range" would also be subject to a modified plan.

"This tailored approach is consistent both with good public policy and with the gradation requirements in section 165 [of the Dodd-Frank Act]," said Tarullo.

While some observers acknowledged the effort, they still questioned whether it could be simplified even further, especially for banks that are close to the $50 billion threshold.

"It could have been worse," said Oliver Ireland, a partner at Morrison & Foerster, noting that the impact on cutbacks made on liquid assets and changes in the measurement period could have a significant effect in which case the regulators could expect a lot of pushback on those issues.

"Effectively what they have done is raised the ratio," said Ireland. "They made it tougher to meet."

The so-called liquidity coverage ratio is intended to prevent the predicament that faced U.S. financial institutions during the financial crisis. At the time, banks facing liquidity strains were forced to sell off positions, triggering a decline in asset prices, higher margin calls and further deleveraging.

"Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system," said Fed Chairman Ben Bernanke at the meeting.

Fed officials hailed the proposal as designed to mitigate those kinds of "destabilizing dynamics" by ensuring that major U.S. banks have a pool of high-quality liquid assets to address possible short-term cash outflows.

Even so, regulators repeatedly stressed that such a requirement represented only the first step in achieving the durability of funding, citing continuing risks associated with short-term wholesale funding and potential fire sales.

"There certainly remains a need to address financial stability risks associated with short-term wholesale funding transactions," said Fed Vice Chairman Janet Yellen, President Obama's pick to be the next chairman of the U.S. central bank.

"These transactions may not pose liquidity risks within the 30-day window, but the rapid sales of underlying assets that would be occasion by an unwind of matched books creates asset fire sales and financial stability risks."

Both she and Tarullo noted the importance of U.S. regulators proceeding with a proposal to implement a long-term liquidity requirement called the net stable funding ratio and reforms on short-term wholesale funding.

"The liquidity coverage ratio, while being an important step, which it surely is, is not an end in itself," said Tarullo, adding that "achieving that end of durability of funding so that you don't get in positions were people are in liquidity squeezes is something that is going to take considerably more work."