WASHINGTON - Regulators are nearing completion of a landmark proposal that would institute a liquidity requirement for financial institutions designed to help buffer against a prolonged market crisis.
The three banking agencies have spent roughly 10 months drafting a U.S. plan to adopt the Basel III requirement, which global regulators amended in January to expand the types of "highly liquid" assets and allow banks to build up their buffer over time instead of immediately.
The proposal, which had been expected as early as this summer, will now be up for discussion and released at an open Federal Reserve Board meeting on Oct. 24, according to a notice posted on the agency's Web site on Thursday.
U.S. banking agencies are largely expected to adhere closely to the revised global liquidity rules, but there are still several key aspects that regulators must adjust in order to match the requirements of Dodd-Frank Act, including avoiding any reference to credit ratings.
Just as we did with Basel III, we adapt the recommendations to fit our domestic situation, Comptroller of the Currency Thomas Curry, told reporters at American Banker's Regulatory Symposium last month.
One key question that remains is the scope of the rule, including what institutions must comply with it.
Under Dodd-Frank, bank holding companies with assets of at least $50 billion face a liquidity stress test and requirements to strengthen liquidity risk management standards.
Its likely that the 30-day liquidity buffer, known as the liquidity coverage ratio, would also apply to those firms. Fed officials have said the financial reform law's requirements will work in tandem with the overall liquidity requirement.
"These quantitative liquidity requirements would complement the stricter set of qualitative liquidity standards that the Federal Reserve has already proposed pursuant to section 165 of the Dodd-Frank Act" Fed Gov. Daniel Tarullo said in prepared testimony before the Senate Banking Committee in July.
It remains unclear, however, how regulators will define two categories of highly liquid assets without utilizing credit ratings.
Under the global rule, highly liquid assets are divided based on their investment grade. U.S. regulators have faced the challenge of developing an alternative approach - a task some observers suggest has slowed down releasing a proposal.
"That may be a reason why it has taken the U.S. banking regulators some time to translate the LCR into a U.S. proposal," said Andrew Fei, an associate at Davis Polk & Wardwell and a Basel expert. "There are these concepts in the international version of the LCR, such as references to credit ratings, that US regulators are not allowed to use in the United States."
U.S. regulators have two alternatives: either make a more granular non-credit-ratings-based distinction between "high" investment grade and "low" investment grade or abandon that aspect in the global framework entirely, Fei said.
Also critical will be how U.S. regulators treat agency paper from Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Under the global agreement, each country has discretion over how it will apply the rules.
"A certain amount of flexibility was given to national regimes in the January announcement," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics. "But the agency paper -- Fannie, Freddie, Home Loan banks -- is so critical in U.S. funding markets and non-existent elsewhere. The final Basel rule doesn't well address it and I expect the U.S. rules will."
Shortly after the Basel Committee on Banking Supervision revised the LCR, Fed Chairman Ben Bernanke hinted at the possibility that regulators would make changes to the rule to fit the U.S. banking system.
"That will be our starting point," said Bernanke, testifying before the Senate Banking Committee on Feb. 26. "We need to start with the international agreement and ask ourselves to what extent to we need to strengthen it, to what extent do we need to customize it for the U.S. context?"
Under the global rule, a bank's buffer could rest at 60% outflows over a 30-day period when the rule becomes effective in 2015, and then increase steadily until reaching 100% four year later.
In recent months, some Fed officials have also sounded the alarm on aspects of the rule that they find troublesome.
Fed Gov. Jeremy Stein said in April that U.S. regulators should carefully weigh how much liquidity from a central bank should be allowed to count toward the global liquidity requirement.
"Policymakers should aim to strike a balance between reducing reliance on the [lender of last resort] on one hand and moderating the costs created by liquidity shortages on the other hand especially those shortages that crop up in times of severe market strain," said Stein.
Fed officials have also been raising concerns about liquidity risks, whether it is the potential of fire sales of short-term wholesale funding, money market mutual funds, or repo markets.
Tarullo and Stein have repeatedly cited potential problems with short-term wholesale funding. Earlier this month, Stein laid out potential regulatory remedies to help lessen the risks associated with fire sales, which would go beyond liquidity rules.
"While many of these tools are likely to be helpful in fortifying individual regulated institutions in reducing the probability that, say, a given bank or broker-dealer will run into solvency or liquidity problems they fall short as a comprehensive, marketwide approach to the fire-sale problems," said Stein in a speech at a conference at the New York Fed on Oct. 4.
What's clear is that the Fed views the liquidity coverage ratio as one part of a broader strategy to address risks to the system. The cases of Lehman Brothers and Bear Stearns showed just how quickly markets can move even within a single day.
"It's still an important piece but there are many pieces," Petrou said. "That's one of the challenges. There are lots of angles to each one of these rules and you get all these separate initiatives aimed at different parts of the problem on different tracks and you can never tell about the sum total impact of all of these rules."