Tarullo: Fed Will Be Flexible in Liquidity Rule Enforcement

WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo said the agency wants to enforce its liquidity rules in such a way as to ensure that accumulated capital can be deployed in times of economic stress.

Speaking before the Clearing House in New York on Thursday, Tarullo said one of the main hazards of developing new rules is the potential for creating unforeseen adverse effects. One such effect of its recently finalized short-term liquidity rule, Tarullo said, is the potential for the Fed's requirements is to potentially exacerbate the tendency of banks to hoard capital during periods of financial stress.

"Firms may fear that dipping below those levels, even in a period of stress, would project weakness to counterparties, investors, and market analysts," Tarullo said. "That is, we may be more successful in enforcing the maintenance of liquid asset buffers in normal times for use in stress periods than we will be in encouraging their use when such a stress period arrives."

For this reason Tarullo said the agency is developing a "context dependent" supervisory approach to its liquidity rules, whereby "a firm that falls out of compliance with [liquidity requirements] during a period of generalized stress should not be subject to automatic sanctions, but instead given an opportunity to come back into compliance in a way that does not expose either the firm or the system to greater stress."

Global regulators have been working since the 2008 financial crisis to establish and enforce global standards for liquidity at systemically important banks. The Basel Committee on Banking Supervision mandated that banks hold enough liquid capital to sustain operations for 30 days — a rule known as the Liquidity Coverage Ratio. The Fed completed its version of the rule in September that included some, but not all, of the industry's requests for what types of assets could qualify as "highly liquid" to meet that requirement.

Basel also last month unveiled its proposed Net Stable Funding Ratio, which requires a certain amount of "available" stable funding on hand to meet liquidity needs beyond the 30-day standard imposed by the LCR. Tarullo offered few hints as to whether, and to what degree, the Fed would go beyond the Basel requirements when it develops its own NSFR rule sometime next year.

But Tarullo's comments suggest that the central bank is mindful of how its rules might play out in the real world. Jaret Seiberg, an analyst with Guggenheim Securities, said in a note that it is "significant that Tarullo recognizes the danger that too much liquidity can cause," adding that the comments "may relieve some concerns over what the new liquidity regime could mean for banks in the next downturn."

Tarullo also noted that since the crisis, the short-term wholesale funding markets have improved from a regulatory point of view. The market has shrunk and the maturity of those loans is longer while collateral haircuts are "more conservative." But that is at least in part because the financial crisis flattened yields throughout the financial system and made lenders more risk-averse — trends that Tarullo said are "likely to prove transitory." Investors, meanwhile, may simply take their funds away from regulated entities and toward unregulated intermediaries, and the Fed may need to act to curb risks beyond the traditional banking sector.

"To the extent that disintermediation of prudentially regulated firms occurs, there will be a need to supplement prudential bank regulation with policy options that can be applied on a market-wide basis, such as a framework of minimum margin requirements for securities financing transactions," Tarullo said.