Regulators Near Release of Final Liquidity Rule

WASHINGTON — Federal regulators are aiming to finalize a rule in early September that would establish a tough new liquidity requirement for banks, according to multiple sources with knowledge of the situation.

The agencies first proposed the plan last October, but have faced intense criticism from the industry related to some of its provisions, including what instruments count as the best forms of liquidity.

With regulators close to a final rule, some in the industry have launched a last-ditch effort to delay it. The American Bankers Association sent a letter to regulators last week asking them to re-propose the plan, arguing it is a new concept that requires more discussion.

"They are near the end but I hope they will look" carefully at the letter, said Wayne Abernathy,executive vice president for financial institutions policy and regulatory affairs with the ABA.

The letter also pointed to the fact that European regulators have delayed implementation of their own liquidity requirements.

"The Europeans are giving some breathing room. Let's take advantage of that," Abernathy said.

At issue is the so-called "liquidity coverage ratio," a requirement designed to provide banks with at least a 30-day buffer in the event of a prolonged financial crisis. While regulators have significant experience with capital ratios, which were strengthened as a result of the crisis, the liquidity ratio is a new and untested measure. It is meant to protect against the types of runs that occurred at Lehman Brothers, which had capital on hand but failed in large part because it was unable to fund itself.

The banking industry supports the need for an LCR, but has had serious problems with the agencies' proposal for imposing the new ratio. Chief among them is how it would define "high quality liquid assets." Under the proposal, those top tier assets would include items like U.S. Treasury bonds, but exclude municipal securities and mortgage-backed securities issued by Fannie Mae and Freddie Mac. (Such assets could be used in calculating the ratio but are given lower tier status, limiting how much could count toward the overall LCR requirement.)

Since last year, the banking industry has adamantly protested the regulators' view of municipal securities and government-sponsored enterprise MBS, arguing they should count as higher quality assets.

"One of the key concerns that need further consideration is the proposal's excessive limitation on the types of assets that qualify as high quality liquid assets, allowing little more than government instruments, " wrote Frank Keating, the president of ABA, in an Aug. 11 letter.

Some analysts said the regulators are likely to give ground in the final rule on how high quality assets are defined. Karen Shaw Petrou, a managing partner with Federal Financial Analytics, noted that the European Union has already expanded the definition to include covered bonds.

"The EU is increasingly going off the global rails and that gives the U.S. greater flexibility," said Petrou. "The EU is giving them cover."

Yet the regulators may not want to go all the way in meeting the industry's concerns, particularly surrounding the GSEs' MBS. Allowing those securities to count as a high quality liquid asset without any limitations could encourage banks to be even more dependent on the GSEs than they already are. That would then make reforming the housing finance system, already a Herculean task, even tougher.

"The best possible liquidity rule has significant worst possible housing consequences, done with the best of intentions," said Petrou.

Still, the industry argues that without changes, there will be too much competition for a limited amount of assets.

"It creates an operationally narrow supply of HQLA [high quality liquid assets] that encourages aggressive acquisition of HQLA in good times and by institutions with the greatest market clout," wrote the ABA's Keating. "Perhaps even more worrisome, the constrained supply of HQLA could precipitate panicked acquisition of HQLA and crisis conditions in times of financial stress, when demand would likely rise sharply and supply disappear."

Also an issue is the regulators' proposed implementation deadline. Under the proposal, banks would have to comply with the LCR beginning Jan. 1. If regulators stuck with that timeline, it would leave banks just three months between the final rule and its implementation date.

The industry is particularly concerned about how banks can comply with certain aspects of the rule within that timeframe, including the requirement that the most complex banks report their daily liquidity inflows and outflow to regulators. Banks say creating such a capacity would take significant time and resources — and without the final rule, it is not certain what is going to be required.

"At this time, it is not clear that covered banks will be able to implement systems necessary to calculate the ratio on a daily basis by the proposed effective date, especially not with the requisite level of confidence in their accuracy," wrote several trade groups, including The Clearing House, ABA and Financial Services Roundtable, in a comment letter sent in May.

But Petrou said the regulators are likely to be flexible in their final rule, recognizing the time constraints.

"I think the agencies will be merciful in terms of implementation," she said.