New Liquidity Rule Will Force Big Banks to Shape Up

The largest U.S. banks will be challenged to comply with the liquidity rule issued Wednesday — and that's a good thing.

The liquidity coverage ratio requires banks to demonstrate that they hold enough liquid assets to survive for at least 30 days in a period of serious market or credit stress. Fortuitously, its requirements for banks with over $250 billion in assets are stricter than the Basel Committee's. Going forward, big banks will have to think seriously about what assets they invest in. They will also be compelled to focus on accumulating and validating data and on developing systems that are capable of rapid, accurate calculations and timely reporting to regulators.

The onus is on banks to demonstrate to regulators that they have the high-quality liquid assets necessary to be in compliance with the rule. Sixty percent of those assets must be cash, central bank reserves, and sovereign and supranational securities that are rated either AA or AAA. Some mortgage-backed securities, corporate bonds and equities also count as liquid assets. These assets are typically less liquid and more volatile than those in the first category.

Fortunately, for the moment, U.S. bank regulators are not allowing municipal securities to count toward compliance with the rule. Municipalities are notorious for having unreliable and opaque financials that come out only once a year—sometimes six months to three years late. These types of securities can hardly be considered high-quality.

The rule should also be lauded for placing big banks on an accelerated timeline for compliance, unlike the Basel liquidity rule. Banks must achieve between 60% to 80% compliance by 2015, continuing in 10% increments through 2017 when the full rule takes effect.

This could be a tall order for some banks. Bank lobbying groups analyzed 17 depository institutions in a July 7 letter to regulators and found that 11 of the 17 would fall short of the proposed liquidity requirement. The groups noted that the institutions would have to increase their liquid assets by a combined $280 billion to achieve full compliance with the proposed rule. (Other estimates, however, have predicted that the shortfall would be much smaller.)

The banking groups' finding is a bit surprising, given that the liquidity rule became part of the Basel Accord in July 2010 and was finalized in January 2013. Big banks have been on notice for quite some time that the rule would eventually apply to them. But by bank lobbyists' own admission, even seven years after the U.S. recession, many institutions lack the liquidity necessary to withstand a shock.

It should be noted that some analysts believe that banks are prepared to meet the liquidity coverage ratio. U.S. banks "will not have an issue meeting the [ratio] and all should be compliant with the new rules," according to Joo-Yung Lee, managing director of financial institutions at Fitch Ratings.

Another advantage of the rule lies in its strict reporting requirements for banks with over $700 billion in assets. Those banks will be required to submit daily reports on the liquidity coverage ratio at the same time each day in order to have consistent metrics. Banks are also required to have a forward-looking, 30-day rolling window for the calculation of net cash outflows to analyze structural changes to their funding profile. This "will prevent [financial institutions] from smoothing one-day spikes (as would be possible with a monthly average) and poses a potential challenge," according to Stephanie Wolf and Rohan Ryan of Bank of America. "Moreover, it could add complexity to reporting requirements, which may have cost implications."

Banks will also be required to notify bank regulators if any day's ratio is less than 100% and to submit a remediation plan if the ratio remains below that level for three consecutive days. This will doubtlessly increase the importance of robust control models for liquidity reporting. Banks will expect that they have to have excess liquidity buffers in order to ensure that the ratio remains above 100%.

A final key difference between the U.S. rule and Basel is that banks are required to evaluate the largest net cumulative outflow position during the 30-day stress period in order to capture the effect of a mismatch between long-term assets and short-term liabilities. It is important that regulators monitor this to make sure that banks can withstand major shocks such as those of 2008.

Of course, no rule is perfect. Thomas Day, senior director at Moody's Analytics, is concerned about "insufficient attention by supervisors to linkages between credit and liquidity scenario planning." I agree that there is not enough industry discussion about this issue. "The crisis was a solvency issue that turned into a market liquidity event," Day notes. "Credit and liquidity need to be considered together.'

The fact that many banks have serious data and reporting challenges could also hamper the effectiveness of the rule. January's senior supervisory report discussed big banks that are still having problems monitoring counterparties, while five banks failed the Federal Reserve's stress test earlier this year. Then there are Deutsche Bank's regulatory reporting problems — not to mention that regulators deemed the living wills of 11 banks not credible.

I urge the media and bank analysts to demand more transparency from banks to determine whether the data used to calculate compliance with the liquidity rule — or to calculate any ratios — can be sufficiently trusted. Only then can we feel that progress is being made toward protecting the U.S. financial sector and taxpayers.

If U.S. banks cannot meet the liquidity rule in a timely manner, they will have to undergo more dramatic changes. The solution would be for banks to raise more equity, sell risky assets that do not help them meet the ratio, lower bonuses and dividends and lessen stock and bond buybacks. This scenario would doubtless be unappealing to many bankers. But in order to better ensure the stability of the U.S. financial system, banks must do what is necessary until they truly have enough liquidity to survive another crisis.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World and The New York Institute of Finance. You can follow her @MRVAssociates.