Cheat Sheet: How Regulators Eased the Final Liquidity Rule

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WASHINGTON — Federal regulators made several key concessions Wednesday in approving a final liquidity rule for the largest banks, but stopped short of making some of the biggest changes requested by the industry.

The rule implementing a new "liquidity coverage ratio" did not accommodate an industry request to include municipal securities among so-called "high-quality liquid assets" banks must hold as a liquidity buffer. Yet the Federal Reserve Board, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency still eased several other requirements, and Fed officials signaled that the agencies plan to explore a future rulemaking that may add municipal securities to the list.

"Staff has been working on ideas to develop some criteria for determining which such bonds fall into this category and thus might be considered for inclusion as HQLA. That work has not yet been completed, and it is important to get this final rule adopted now, so that the largest banks can begin to prepare for its implementation on January 1," Fed Gov. Daniel Tarullo said at the central bank's open board meeting. "However, I anticipate that staff will be coming back to us with a report on efforts to develop a proposal along these lines."

The agencies finalized the liquidity regulation on the same day they also re-proposed swaps margin requirements to implement a derivatives provision in the Dodd-Frank Act, and issued final changes on how large banks must calculate a new, stricter capital yardstick known as the "supplemental leverage ratio."

On the final LCR regulation, the regulators appeared to want to take incremental steps, at least, to dial back the operational impact of the new liquidity standard on the industry. The rule definitely exempts "systemically important" nonbanks from the liquidity requirement, gives banks added time before having to calculate daily LCRs and addresses industry concerns about how the proposal would have treated certain instruments such as municipal deposits.

The liquidity rule is U.S. regulators' version of a Basel Committee standard requiring a stronger liquidity safeguard, which large institutions lacked at the height of the 2008 crisis. Under the rule, large banks must maintain "HQLAs" to cover cash outflows over a 30-day period when economic conditions became stressed.

"As the financial crisis demonstrated, most of our largest and most systemically important financial institutions used excessive amounts of short-term wholesale funds and did not hold a sufficient amount of high-quality liquid assets to independently withstand the stressed market environment," Fed Chair Janet Yellen said at the Fed's meeting. "In the wake of the crisis, regulatory bodies from around the globe convened to develop the first internationally consistent quantitative liquidity standard for banking firms. The final rule under consideration today will complement the Federal Reserve's enhanced supervision and regulation of these firms' liquidity positions and thus further bolster financial stability."

Here is a rundown of the final LCR's key components, including how it was changed from the proposal.

Most of last year's proposal is intact
The final version of the rule is largely similar to the plan released in October. The LCR is principally focused on banking companies with at least $250 billion in total assets or consolidated on-balance sheet foreign exposures of at least $10 billion. But the rule also makes available a simpler — or "modified" — LCR standard for those that have at least $50 billion in assets but less than the higher asset threshold.

HQLAs are divided into three categories. Assets considered the safest are in the "level 1" category — including cash and U.S. Treasuries — and can be used to fulfill the LCR requirement without limit. The second tier, known as "level 2A" assets, includes government-sponsored enterprise securities, but they have a 15% haircut in the calculation of the ratio. The third tier, "level 2B" assets, includes certain corporate debt and equity instruments. The third category is subject to a 50% haircut. A bank's level 2B assets can make up no more than 15% of its HQLAs, while the total of 2A and 2B assets is limited to 40%.

Banks had wanted the U.S. regulators to follow the Basel Committee and not require full LCR compliance until 2019. The agencies retained a faster timeframe in the final rule, but will still allow firms subject to the primary LCR rule to phase in minimum LCR levels over a three-year period. By Jan. 1, firms must have enough HQLAs to cover 80% of cash outflows. That ratio rises to 90% on Jan. 1, 2016, and to 100% on Jan. 1, 2017. However, smaller companies subject to the simpler "modified" version of the LCR effectively have a minimum ratio requirement of 70%.

Municipal deposits and other holdings win better treatment
While the issue of whether municipal bonds will be treated as high quality assets is unsettled, the regulators did address some of the concerns about how other types of assets were treated in the proposal.

For example, the final rule removes a requirement in the proposal that corporate debt securities be publicly traded on a national exchange to get HQLA treatment. Such securities could get recognition under the final regulation if they are investment grade, issued by a nonfinancial entity and have a track record of being a strong liquidity source.

In addition, a certain category of HQLAs that are publicly traded common equity shares — that under the proposal could be recognized if listed in the S&P 500 Index — were expanded in the final version to also include those listed in the Russell 1000 Index.

Meanwhile, the proposal had sought to limit banks' ability to overload on certain secured funding transactions — such as repurchase or reverse repurchase transactions — that mature quickly and could give the false appearance of ample level 1 HQLAs. But limits on secured transactions would have resulted in unfavorable treatment to state, municipal and corporate trust deposits, which are all typically secured. As a result, the final rule removes such deposits from that category of transaction.

Nonbank liquidity requirements will be addressed in later policies
Whereas the proposal had included nonbank companies designated as "systemically important" by the Financial Stability Oversight Council as needing to maintain an LCR, the final rule omits such firms. The Fed, which under Dodd-Frank is tasked with setting prudential supervisory standards for FSOC-designated entities, signaled it would address liquidity requirements for nonbanks under future policies.

"Liquidity standards would be applied to those institutions through rule or order, based among other things on an evaluation of the business model of each designated firm," Tarullo said.

Other changes
While the agencies resisted calls to adopt the more generous 2019 implementation deadline for international companies under Basel, U.S. regulators are recommending a new transition period to allow companies more time to begin calculating their LCRs on a daily basis. During the phase-in, firms must calculate their LCRs at the end of the month starting on Jan. 1.

The biggest banks — those with at least $700 billion in total assets or $10 trillion in asset under custody — have until July 1, 2015 to be able to calculate daily LCRs. Firms below those asset thresholds but with at least $250 billion in total assets or $10 billion in foreign exposures have until July 1, 2016. Smaller firms subject to the "modified" LCR must only calculate their ratios at the end of each month, starting Jan. 1, 2016.

The proposal would have also required companies following the modified LCR to calculate the liquidity ratio based on outflows over a 21-day stressed period, instead of the 30-day period used for the more expanded rule. But industry commenters raised concerns about the operational complexity of a 21-day period. As a result, the final rule uses a 30-day period for both versions of the rule.

Swaps margin requirement and "leverage ratio" revisions
The agencies also issued a second proposal on the required margin banks must use to curb risk in swaps transactions. The regulators had initially proposed margin standards in 2011 to implement Dodd-Frank, but took another stab at the proposal following the Basel Committee's release last year of a margin framework for non-cleared swaps.

Unlike the 2011 proposal, which only related to the margin banks collect in swaps transactions, the new plan also encompasses margin that a bank "posts" to a counterparty in a deal. (Banks will have 60 days, from when the proposal is published in the Federal Register, to comment.)

Under the proposal, banks that engage in derivatives trades with either swaps entities or financial end users that have significant swaps exposure must calculate initial margin levels using one of two methods.

One approach would be to use a standardized margin schedule for specific types of transactions outlined by the regulators. But under an alternative approach, which may become the most common option used by institutions, banks could use a risk-based, internal model to measure how much margin to post and collect on swaps transactions. However, even under the risk-based approach, the amount of margin calculated would still have to be sufficient to cover potential extreme losses based on the behavior of similar transactions in past crises.

In cases where a bank engages in a swaps transaction with a financial end user that has limited swap exposure, or with a nonfinancial end user, the proposal essentially does not require a specific margin amount.

Meanwhile, the agencies also finalized changes to the types of assets large banks must use to calculate a tougher capital standard known as the "supplemental leverage ratio."

The agencies had previously established a higher leverage ratio for the biggest domestic banks — of 5% for holding companies and 6% for their insured subsidiaries — than that set by the Basel committee. But in April, they proposed how to implement recent Basel changes to what constitutes the denominator.

The final rule effectively results in an even stricter leverage ratio requirement, with the denominator more holistically capturing on- and off-balance sheet items. The rule adjusts how derivative contracts and repo-style deals go into the calculation of a bank's "total leverage exposure." Now included in total leverage exposures are cash serving as collateral for derivatives contracts and a measure for the counterparty credit risk in repo-style transactions, among other items.

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