Banks urge Fed to revise liquidity rule after pandemic shock

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WASHINGTON — For many months, regulators have relaxed regulatory standards in order to help banks weather the COVID-19 crisis. But an impending liquidity benchmark will test the largest institutions' ability to support the fragile economy while complying with new rules.

The federal agencies are poised soon to finalize the Net Stable Funding Ratio, a measure of long-term liquidity strength developed after the financial crisis by the international Basel Committee.

But some in the industry and other analysts say finalizing the rule, not long after the coronavirus outbreak triggered volatility in the liquidity markets, is playing with fire. They point to the sudden selloff in Treasury securities in the spring, which led the Fed to buy up Treasuries, saying that the new liquidity ratio could make it hard for banks to respond if the market suffered another such shock in the future.

The Bank Policy Institute warned in a recent blog post that “adopting the NSFR at this time would be both ironic and reckless.”

Bill Nelson, the chief economist at the institute, said in an interview that the NSFR’s treatment of Treasury securities would have exacterbated the market volatility that necessitated an unprecedented intervention from the Fed. He noted the events of this past spring proved that banks could weather the storm without a new liquidity requirement.

“It does make it ironic that they are adopting this in the wake of events for which it was demonstrably not needed, and it would have made it worse,” Nelson said.

Banks are already complying with a short-term funding measure known as the Liquidity Coverage Ratio, which gauges banks' ability to withstand a sudden market crisis over a 30-day period. In contrast, the NSFR assesses a bank's ability to fund the asset side of its balance sheet for one year.

According to the 2016 proposal by the Federal Reserve Board, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, the rule would apply risk weights to different types of assets and liabilities. An institution's "available stable funding" would have to equal or exceed "required stable funding." The proposal would generally apply to banks with over $250 billion of assets, although less complex institutions would comply with a modified version. The NSFR proposal hewed fairly closely to the international standard set by the Basel Committee.

Despite hope from many big banks that the NSFR was all but dead, Fed Vice Chairman for Supervision Randal Quarles said last week that he believed the rule would be finished “quite soon.” The Fed is leading the charge among the regulators to complete the rule, according to Politico.

Quarles, speaking at an event for Harvard Law School, suggested that regulators will finalize the NSFR as well as a separate package of other Basel III requirements.

"The COVID event and the fact that there are only 24 hours in a day, I think, slowed us up a bit in implementing that," Quarles said. "But we’ve picked all of that back up and that will proceed at pace as well. I think those will be complete over the near to medium term and that will be all the major elements then that we sought to address will be addressed.”

Some analysts say that even though banks' liquidity profiles right now are not overly risky, the rule is still necessary to ward off risky behavior in the future.

“As an analyst, I've seen this over time that if you don't have any guardrails or any rules, you will create bad actors,” said Chris Marinac, director of research at Janney Montgomery Scott. “Maybe the acting is not bad today, but it could be bad tomorrow because you didn't have any guardrails.”

But Nelson suggested that the Fed should weigh the rule against the recent volatility in the Treasury market. For example, the final rule could set the stable funding requirement on Treasury purchases and reverse Treasury repurchases to zero in order to mitigage balance-sheet constraints and prevent another episode of volatility in the future.

He noted that other international jurisdictions have instituted such changes, which deviate from the Basel Committee agreement. "Importantly, this is the way that the European Union addressed this problem," he said.

Yet others urged regulators to remain tough and said the rule will have clear benefits.

Bartlett Naylor, a financial policy advocate at Public Citizen, argued that the Treasury market disruptions in the spring that sapped market liquidity probably require more study to determine the root cause, and it’s unclear what effect the NSFR would have had.

“I would say that what happened in the spring deserves a lot of analysis, because it’s unclear what problems existed that the Fed intervened to stop,” he said. “The fact that the Fed had to do anything I think says that the banking system was not able to carry on by itself.”

David Portilla, a partner at Debevoise & Plimpton and a former Treasury official, said the Treasury market instability did indeed sap liquidity. But the effects of such volatility should be part of a conversation about the post-2008 regulatory regime, he said.

“I don't think that's an NSFR-only debate, but it seems like that's a broader debate about the prudential framework more generally, and what lessons you can draw from the market volatility that occurred through March in particular,” he said.

But the recent unprecedented rise in consumer deposits at banks could also make it easier for banks to comply with the NSFR while still being able to continue lending, said Marinac. Deposits at banks jumped by 13.3% in the first quarter from a year earlier, to $15.8 trillion, the biggest year-over-year increase measured by the FDIC.

“I really think that the system is flush with deposits, and banks can really kind of make hay when the sun shines in terms of getting core funding, getting some of those ratios improved or just meeting the standard that the Fed has,” said Marinac. “As an analyst, I worry less about it than I would have three or four years ago when interest rates were higher.”

The Fed has also indicated it is willing to be flexible with liquidity requirements to ensure banks are able to continue lending to households and businesses.

The NSFR is intended to serve as a complement to the Liquidity Coverage Ratio. In May, bank regulators modified the LCR to better enable banks to participate in two of the Fed’s emergency lending facilities.

“If the banks really felt threatened, they would constrict lending,” said Marinac. “For the greater industry, I don't think the Fed wants to be too tough, because then it basically makes it harder for banks to lend.”

Liquidity rules like the NSFR and the LCR act as safeguards, and are supposed to prevent a repeat of the 2008 financial meltdown, Naylor said.

“We’re concerned that the [banks] like to live life on the edge with as little liquidity coverage and as low a Net Stable Funding Ratio as they can get away with,” he said. “You make more money with more complicated investments, and we think that complication poses risks.”

But Nelson countered that banks should be trusted to self-regulate. Banks have so far fared well since the onset of the coronavirus, and have played important roles in the path toward economic recovery by facilitating emergency loans to small businesses through various government programs, he said.

“As far as banks not managing their own liquidity, I'd say we've just had the stress test here to end all stress tests, and the banks passed it with flying colors,” he said.

Marinac agreed that bank liquidity is currently robust, but that fact, he argued, makes meeting a new liquidity standard like the NSFR a much easier target.

“My observation is that liquidity is super strong in the industry right now … so I feel like this shouldn't be that hard,” he said. “If you have a bank that's struggling on this net funding ratio, that really tells you something, because I think the bar is lower.”

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Liquidity requirements NSFR Basel Committee on Banking Supervision Federal Reserve FDIC OCC Coronavirus Deposits Liquidity