WASHINGTON The Federal Reserve Board proposed a change Thursday to its recently finalized liquidity rules for the largest U.S. banks that would allow certain municipal and state bonds to qualify as high-quality liquid assets.
Among the chief reforms outlined in the Dodd-Frank Act was the weaning of banks off of short-term wholesale funding as a means to meeting day-to-day liquidity needs. The Basel III international accord, and its subsequent implementation in the U.S., addressed that issue by requiring banks to keep enough high-quality liquid assets on hand to maintain operations for 30 days in the event of a stress event in the market.
That rule, known as the liquidity coverage ratio, outlines what kinds of assets qualify as high-quality, which can be easily converted in times of crisis. The final rule gave various criteria for such assets, including having active repurchase markets at all times, a diverse and large market of buyers, and high volume.
The proposal released Thursday would widen which assets could count as high quality.
"The recent financial crisis highlighted the need for enhanced liquidity risk-management practices at the largest financial institutions," the Fed said in a statement. "The proposed rule released Thursday would maintain the strong liquidity standards of the LCR while providing banks with the flexibility to hold a wider range of HQLA."
There are three categories of assets, each subject to different requirements and haircuts based on the relative liquidity and risk profiles. Level 1 assets are balances held at Federal Reserve banks or foreign central bank, U.S.-backed securities and securities backed by certain foreign governments or the World Bank and International Monetary Fund. Those assets are subject to no haircuts and can meet the entirety of a bank's LCR obligations. Level 2A assets are securities backed by government-sponsored enterprises and other foreign securities that don't qualify as level 1, and are subject to a 15% haircut. Level 2B is even less liquid and more volatile, and are subject to a 50% haircut. A bank's LCR cannot consist of more than 40% of Level 2A and 2B assets combined, and Level 2B may not exceed 15% of the total high-quality-asset level.
The proposal would allow certain municipal and state bonds to qualify as Level 2B assets, but with some limits. Only general obligation municipal securities, rather than revenue obligations, would qualify, and they would have to be investment grade and have a "proven record as a reliable source of liquidity" in repurchase or sales markets. Only U.S. municipalities and states are eligible. Bonds also must not be obligations of a financial sector company or subsidiary. The rule also sets out requirements for municipal bond holdings to be diversified, so that the bonds' price doesn't dip if the bank has to sell them off in a time of stress.
The board will take comment on the proposal through July 24.