Fed's Liquidity Plan Could Spur Collateral Shortfall

WASHINGTON — Top Federal Reserve Board officials are cautiously eyeing the possibility that a new liquidity proposal may incite a collateral shortfall just as the central bank starts to unwind its easy-money policies.

It is not a near-term problem as the central bank continues to push off changing course on its $85 billion monthly bond buying program, but Fed officials are weighing the negative ramifications of forcing banks to meet a slew of new regulatory rules and how such requirements will interact with its monetary policy decision-making in the future.

Specifically, Fed officials are worried about possible unintended consequences that may result when the central bank begins to unwind its balance sheet, ultimately causing the $2.4 trillion held in reserves to shrink back to its precrisis levels. That could potentially spark a shortfall of high-quality assets available to U.S. institutions to meet a proposed liquidity requirement that goes into effect in 2015.

"As we move forward, as we envision the Fed's balance sheet shrinking, is it possible that we will end up with such a rush into these liquid assets? Could we have some kind of unintended interaction that would cause asset prices on these very liquid assets to increase?" said Kevin Jacques, a finance professor at Baldwin Wallace University and a former official at the Office of the Comptroller of Currency. "I think the Fed recognizes that it is entirely possible."

Robin Lumsdaine, a former Fed official and now a professor at American University, says U.S. regulators are concerned over the possibility of causing a liquidity freeze-up when the Fed begins to taper.

"Generally people are asking, 'As the market starts to return back to operating on its own, are folks just going to be hoarding stuff? Is liquidity going to seize up again because nobody's willing to transact?' " said Lumsdaine. "So it's natural to worry about this in the context of unwinding QE as well — is there some risk that it will exacerbate the concerns that are already out there."

As a result, regulators will be cautious to make sure their actions and the timing of those moves don't worsen the situation.

The U.S. central bank would like to prevent a scenario where financial institutions would forcibly rush into the same assets at the same time during a financial crisis, potentially causing a spillover as the market jumps out of one asset and into another. If the new liquidity plan is finalized in its current form, financial institutions are collectively short by roughly $200 billion, according to Fed officials.

"They're very focused on the asset shortage as a significant complication for monetary policy," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics.

The new liquidity proposal would require the largest U.S. financial institutions to hold enough high-quality liquid assets, like excess reserves held at the Fed and U.S. government securities, over a 30-day period to prevent a liquidity strain during a financial crisis.

Janet Yellen, the current vice chairman and President Obama's nominee to become the next Fed chairman, raised that issue during a public board meeting last month as governors discussed a plan to instate a liquidity coverage ratio in the U.S.

"One day in the distant future, if we were to shrink our reserve back to pre-crisis levels, would you be worrying about the inadequate supply of high-quality liquid assets?" Yellen asked Fed staff during the Oct. 24 meeting.

In prior years, regulation has had little intersection with the Fed's balance sheet, but as they become more connected regulators have purposefully probed the impact such ties have on one another.

"As a result of the financial crisis, banking regulation and monetary policy have become more intertwined, via emphasis on systemic risk mitigation and the designation of SIFIs [systemically important financial institutions]," said Lumsdaine.

Bill Nelson, the Fed's deputy director of the monetary policy decision, said at the meeting that there would be no cause for worry given that when the agency began lowering the amount of its reserve balances, it would be occurring at the same time Treasury and agency securities held by the central bank would also be declining dollar for dollar. As a result, such high-quality liquid assets would be more readily available to other market participants to fulfill their liquidity needs.

But demand for such liquid assets by banks goes well beyond just the proposed liquidity requirement, observers warn. Other proposed regulatory requirements like the over-the-counter collateral rule, which would also impose a demand for high-quality liquid assets, would exacerbate any potential shortfall in securities over the longer run.

"There is a real concern about a shortfall of eligible collateral over time," said Greg Lyons, a partner at Debevoise & Plimpton. "I don't think it's an immediate issue, but I do think it's a classic issue of not really understanding what the ramifications may be."

U.S. regulators tried to strike a balance in the liquidity proposal to help ward off the potential for collateral shortfalls by expanding the differing kinds of assets that could be applied to meet the ratio and in some cases provided haircuts for those assets that were less liquid. They even excluded certain assets like covered bonds, mortgage-backed private label securities and municipals from counting given their relative lack of liquidity.

"It certainly will help, but I think it will only help much," said Lyons, pointing to the fact that the second tier of assets, including claims guaranteed by Fannie Mae and Freddie Mac, which are subject to a 15% haircut, are capped at a maximum amount of 40% of a bank's holdings.

Alternatively, banks could adjust the liability side of their balance sheet in order to meet the liquidity requirement as well.

The question, however, will be the extent to which regulators will exercise flexibility, or conversely how strict they will be in enforcing banks to meet the liquidity requirement given there will be periods were banks are likely to fall below the ratio — a message that has been a confusing one, according to observers.

"I think they need to decide whether or not the U.S. liquidity coverage ratio is the minimum level and big banks will need to have taken into account worse case stress scenarios in which case they should be enforcing it vigorously. Or if it is in fact so tough a standard it is meant to be a buffer and you can fall below it under stress," said Petrou. "They keep saying you have to hold all of these robust assets and be resilient even under acute stress, but if you fall below it that might not be so bad."

Others agree, suggesting that there is an apparent tension between regulators not wanting banks to fall below the ratio, but understanding that during a time of crisis it may happen. It's complicated even further by potential disclosure issues, which would give banks an incentive banks not to fall below the ratio and strive to keep even higher ratios well above the minimum.

"I think a bank is going to do a lot of things to protect itself from falling beneath that ratio once it's in place, because that can mean a canary in a coal mine in the eyes of investors that the bank is starting to enter some real difficulty," said Lyons.

For now, regulators have agreed to shut off a safety valve for the largest financial institutions in disallowing funds from the discount window to count towards fulfilling the new liquidity requirement. But in the event of a financial crisis, banks would be allowed to draw on the central bank as the lender of last resort.

Governments and central banks around the globe were forced to provide unprecedented liquidity support to financial institutions to unclog the severe stress that had befallen the financial system during the 2008 financial crisis — a situation Fed officials would like to see unrepeated.

The hope is that the landmark liquidity proposal will incentivize banks to prepare early enough to avoid such liquidity strains as seen during the previous crisis.

"This proposal, if finalized and implemented, is an attempt to reduce the possibility that such liquidity supports on a massive scale would be necessary again," Fed Gov. Sarah Bloom Raskin said at the meeting.