Big Banks Push for Fixes to Liquidity Rules

WASHINGTON — Big banks are urging regulators to make changes to how they calculate a long-term liquidity requirement that they claim is deeply flawed.

The Clearing House Association, whose members include JPMorgan Chase, Bank of America and Citigroup, released a 28-page study last week that argued that a global liquidity requirement — still being ironed out by the Basel Committee on Banking Supervision — needs to be revamped to reflect the progress already made by U.S. commercial banks in their liquidity profiles.

"Our empirical research suggests that U.S. commercial banks have made significant improvements in liquidity since 2010," said Brett Waxman, senior vice president and associate general counsel. "Unfortunately, these improvements are not reflected under the … current formulation."

According to the trade group's study, U.S. commercial banks have made strides in improving their liquidity positions during the past three years by reducing their reliance on wholesale funding, net short-term funding and interbank loans by $248 billion, $584 billion and $42.4 billion. At the same time, those institutions have increased their demand deposits, a more stable source of liquidity, by $308 billion.

Regulators, led by Federal Reserve Board Gov. Daniel Tarullo, have repeatedly warned of the risks associated with short-term wholesale funding. In June, the governor, who heads bank supervision and regulation at the Fed, said the agency is currently working on possible approaches to address such risks, including requiring banks to hold more capital.

Even with such forthcoming proposals, U.S. and global regulators agree with the industry that changes ought to be made to the proposed net stable funding ratio, but have not yet specifically addressed how they will proceed. The Basel Committee has said it hopes to finalize changes in 2014, but a final rule won't take effect until 2018.

The Clearing House hopes its new data might sway regulators to ease off from their initial proposal.

"What we are trying to do is contribute to the discussion and engage in a dialogue with the regulators, and to walk them through the findings in our paper," Waxman said. "They have publicly stated they will be making revisions to the metric, but they have not given any more details about where they may be making these changes."

Under the Basel III agreement, regulators are seeking to require banks to comply with two new liquidity ratios — the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) — each designed for short-term and long-term liquidity needs.

Regulators went back to the drawing board to amend their calculations on the LCR after being criticized for being too stringent. In January, they reached reached a compromise deal to salvage the earlier proposal by expanding the types of "highly liquid" assets that could be included in a required liquidity buffer.

The industry is hopeful that regulators will do so again, especially as it sees a number of areas to improve how to calculate the NSFR.

Regulators have also signaled they still see flaws with the latest approach. In May, Tarullo acknowledged he had concerns about both ratios because they "rest on the implicit presumption that a firm with a perfectly matched book is in a fundamentally stable position."

"Under some conditions, the disorderly unwind of a single, large SFT [securities financing transactions] book, even one that was quite well maturity matched, could set off the kind of unfavorable dynamic described earlier," Tarullo said in a speech on May 3 at the Peterson Institute for International Economics. "Second, creating liquidity levels substantially higher than those contemplated in the LCR and eventual NSFR may not be the most efficient way for some firms to become better insulated from the run risk that can lead to adverse feedback loop and contagion possibilities."

In its report, the trade group urged the Basel Committee and the agencies to revise the structure and underlying assumptions of the NSFR framework.

"If a metric like the existing formulation of the NSFR is nevertheless to ultimately be implemented — and even if it is properly situated as only one liquidity measure among several, as we have advocated — it is critical that, at minimum, it be calibrated more carefully and more granularly so as to accurately reflect industry experience," according to the report.

For example, they argue wholesale deposits are calculated in a way that implies a higher run-off rate than was experienced by banks during the financial crisis. For the net stable funding ratio, unlike the LCR, regulators don't differentiate between nonoperational and operational deposits. If they did, it would capture the reality of such deposits, while also narrowing the shortfall of banks to meet the NSFR by $887 billion, the report said.

The Clearing House is also seeking the recalibration of U.S. government-sponsored enterprises mortgage-backed securities, which under the current proposal call for 20% stable funding, while other U.S. government securities require only 5% stable funding.

"This results in differential treatment of securities issued by Ginnie Mae (which have explicit government backing) and those issued by Fannie Mae and Freddie Mac (which do not have explicit government backing but have been effectively supported by the U.S. government since entering conservatorship in 2008), when historically the market has not reflected any such distinction," the report says.

By aligning GSE mortgage-backeds, it would decrease banks' shortfall in meeting the NSFR by roughly $155 billion, according to the report.

If these flaws in the net stable funding ratio are not corrected, the group warns, it could negatively impact the economy.

"There could be distortions in the markets for some types of longer-term securities" as well as "reduced lending by banks as they replace loans with investments in more highly liquid assets," Waxman said.

The current aggregate shortfall of U.S. banks based on the Clearing House's study ranges from roughly $1.4 trillion to $2.4 trillion, depending on whether financial institutions are assumed to manage to a 100% NSFR or a 110% NSFR.

"Closing this gap would likely require U.S. banks to turn to the capital markets to raise longer-term funding in large quantities over a relatively short period of time, increasing overall costs of funding and depressing banks' net interest margins, returns on equity and willingness to lend to customers of all types," the report says.