WASHINGTON — U.S. banking regulators are proposing to exclude municipal securities as high quality liquid assets in a rule designed to ensure banks and other large financial institutions are equipped to handle severe financial and economic stress. But Fitch Ratings, Citigroup Global Markets, and muni issuers are warning the proposal could seriously hurt the municipal market.

"If implemented as currently written, [the proposed rule] will exclude municipal bonds from the definition of HQLA used in calculating a bank's liquidity ratio," Fitch said in a release issued Thursday. "This may cause banks to begin reducing their holdings in municipal bonds and reinvesting in securities that could be counted as HQLA," Fitch said.

"It would be more expensive for banks to hold municipal bonds on their balance sheets and therefore banks that also serve as dealers may become hesitant to provide liquidity in the secondary market using proprietary capital, increasing liquidity risk for municipal bondholders," the rating agency said.

As of the Federal Reserve Systems' Financial Accounts of the U.S. released for the third quarter of 2013, United States-chartered depository institutions held about $404 billion of the current $3.69 trillion of outstanding municipal securities and loans.

Fitch issued the release the day before comments are due on the proposed rule, which was released in November by the Treasury Department, the Federal Reserve System's Board of Governors, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.

The proposed rule would implement a quantitative liquidity requirement consistent with the liquidity coverage ratio established by the Basel Committee on Banking Supervision for large internationally active banks and other financial institutions.

The intent of the proposed rule is to insure banks have enough high quality liquid assets that would allow them to absorb shocks from financial or economic stress.

But Citi warned in an 11-page letter sent to banking regulators late last year: "As presently constructed ... the proposed rule also serves to impair a long history of legislative motivation for banks to serve and support the municipal securities market."

"Without having offered any demonstration of diminished liquidity, the agencies have proposed not to allow municipal bonds to qualify as high quality liquid assets at this time and, in doing so, propose to dampen bank demand for the asset class."

"The immediate and direct consequence of the exclusion [for] municipal issuers and their taxpaying constituents will be unnecessary, and in many instances unbearable, increases in the cost of financing desperately needed repair and replacement of municipal infrastructure."

Citi urged the bank regulators to reconsider their proposal and include munis as HQLAs.

Durham, N.C.'s Mayor William [Bill] V. Bell also urged the banking regulators to make munis HQLAs, claiming the proposed exclusion of munis "is unjustified based on the agencies' own liquidity criteria and our understanding of the municipal market."

Munis generally carry high credit ratings, have low default rates, particularly compared with corporate debt and can be pledged at central banks, Bell said in a four-page letter dated Jan. 22. There is a large and well-established market for municipal debt, where price volatility has been relatively low during periods of stress, compared to corporate bonds, he said.

"Leaving this debt out of HQLA will have a negative impact on the bond market, the nation's infrastructure, the debt management of state and local governments, and the health of the U.S. economy more broadly," Bell said.

Clay Hicks, cash and debt manager for Guilford County, N.C., sent a very similar letter to the banking regulators, pointing out, as Bell did, that North Carolina has more than $34 billion of bonds outstanding.

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