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New Fight Brewing Over Basel III, This Time Over Liquidity Requirements

WASHINGTON — The largest U.S. banks are quietly preparing to push back against proposed Basel III liquidity requirements that they argue could wreak havoc in the market by artificially deflating the value of certain assets.

Until now, most of the focus on the international accord has been on proposed capital standards, but JPMorgan Chase & Co. is spearheading an effort to help persuade regulators of the potential harm as a result of the so-called liquidity coverage ratio.

The bank, along with others, is expected to present a white paper to the agencies within the next few months to change what they say is a very conservative rule that would lead to a raft of unintended consequences.

"It's an issue in the industry and the CFOs and the treasurers of the major U.S. banks are working together on a summary and approach that we can provide to regulators in the government," said Joe Bonocore, corporate treasurer of JPMorgan Chase, in an interview with American Banker.

Bonocore declined to name the other banks involved, saying it was still early in the process. But he said several large institutions are worried about the impact of the liquidity requirements if there are no changes to the plan.

At issue is a measure proposed by the Basel Committee on Banking Supervision that is intended to ensure banks have adequate liquidity when the next financial crisis occurs. During the housing crisis, several banks had adequate capital, but ultimately failed because of a shortage of easily liquid assets.

Under a proposal issued last year, banks would have to ensure they could survive a short-term financial stress that lasts no more than 30 days. During that time, regulators want to ensure outflows are matched by inflows in the event of a run on the banks. Banks are required to comply with the new rules starting in January 2015.

Regulators have separately proposed a net stable funding ratio, which looks to ensure funding over a longer period of stress, but that won't become binding until January 2018.

For now, the largest financial institutions have remained focused on pushing for possible changes to the short-term liquidity coverage ratio.

As currently written, the proposal assumes that the vast majority of deposits made by consumers would leave any particular bank within 30 days. As a result, banks would no longer receive credit for such deposits in order to meet short-term liquidity requirements under Basel III.

Instead, banks would have to alter their funding profiles leading to more demand for long-term funding and holding significantly more liquid, low-yielding assets to meet the requirement.

The approach global regulators have taken essentially splits assets into two categories, while assigning a liquidity rating based largely on how quickly institutions would anticipate liabilities to be drawn upon within a month's time.

As drafted, most of the assets deemed as highly liquid would be narrowed to long-term unsecured debt in the form of U.S. Treasuries.

Instruments like gold, triple-A-rated asset-backed securities or Federal Home Loan bank advances, meanwhile, would be assigned a liquidity rating of zero and receive no credit. Bankers said that is overly harsh, noting that, for example, Home Loan bank advances were a strong source of liquidity in the crisis, while gold is considered a flight-to-quality asset.

"If you look at the types of calibrations that they are putting around asset liquidity, you're almost bifurcating the market," Bonocore said. "Assets either fully qualify or don't qualify at all. There's no in between, except for a few asset classes. The problem with that, as we all know, is that's not the way markets behave."

JPMorgan Chase argues that if the proposal is not changed, there will be lower extensions of credit, less diversified investment portfolios, significantly lower net interest margin and much higher long-term debt. All of that will hurt consumers and the economy, Bonocore said.

"If you end up with a situation where the rules survive as they exist now, it may have a very significant, unfavorable impact on the markets in general and clients in particular," Bonocore said. "You may see less desire to extend credit, which is not good for the economy and not good for recovery."

Industry observers agree it is a significant issue.

"The liquidity rule is designed to show how much cash on hand do you have to meet any calls that you might have for it," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. "These runoff rates never materialized during the crisis. The way the runoff rates are calibrated puts a tremendous amount of stress on the bank in ways they don't think is warranted."

Bankers worry that with more banks out in the market trying to convince investors to buy debt, such credit will become vastly more expensive, raising the banks' costs, which they will then pass on to consumers.

Regulators, Bonocore said, need to be more realistic about the true liquidity value of assets.

"You could be potentially eliminating a large number of instruments that banks would want to hold in their portfolios because there is no liquidity value attributed to them," Bonocore said.

Analysts — and even the banks themselves — recognize that they face an uphill battle in convincing regulators to reopen the issue.

"The industry is going to have to make a credible, convincing case because we've just been through a financial crisis — and the regulators are in a bit of a proven mode, which I think is warranted and fair," Petrou said.

The issue has remained quiet to date because U.S. regulators have yet to detail how they plan to implement the new liquidity requirements. Once that happens, the industry is likely to direct more attention to it.

"There's no U.S. proposal, so we don't know yet how broadly it's going to be applied," said Hugh Carney, general counsel for the American Bankers Association and former attorney for the Office of the Comptroller of the Currency. "I would imagine you are going to be hearing a lot of noise once the proposal in the U.S. comes out."

But the Basel Committee has already agreed to revisit the issue at a later date and make changes as warranted. It will conduct a quantitative impact study using midyear and yearend 2010 data.

"They're still going to be calibrating liquidity ratios as time goes on and during the observation period they are going to be able to look and see how banks are doing and if there are any changes that need to be made," Carney said. But "it's unclear what future changes will come."

At this point, it's unknown whether the scope of the rule would be applied only to the largest banks, or if other institutions may also face similar requirements.

To be sure, bankers are not arguing that there is no need for a liquidity ratio at all, just that it needs to be more dynamic.

"The fact that some banks didn't manage to a stronger liquidity profile, in my opinion, was one key cause of the crisis," Bonocore said. But "the current calibrations actually take a very good concept, and a very good mechanical framework, and turn it into something that can be less beneficial to markets and consumers."

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