The Fed Votes Y-E-S on the LCR

What does the finalization of another regulatory requirement mean for markets?

The US took another step toward adopting 2010's international banking standards (aka Basel III) Wednesday, when the Fed released and approved the final Liquidity Coverage Ratio(LCR)-a new capital requirement designed to keep big banks afloat during a run. Like most of Basel III (and Dodd-Frank), it probably isn't the prophylactic regulators presume, but on the bright side, it shouldn't create headwinds for Financials or bank lending-and its finalization offers banks a bit of relief from lingering regulatory uncertainty.

Like all of Basel III, while regulators globally agreed to the LCR's basic framework, each country has some latitude in how they design their own rule. The Fed's initial proposal, released last October, was tougher than the Basel standards-like Basel, it required big banks to keep enough "high quality liquid assets" (HQLA) to cover 30 days of expected withdrawals and operating costs during a bank run (another too-big-to-fail "fix"), but the HQLA pool was smaller, and the phase-in window was cut from four years to two. The Fed also proposed a separate LCR for midsized banks, requiring them to hold enough HQLA to cover 21 days of panic.[i]

The final rule-approved by the Fed and pending with the FDIC and OCC-is largely in line with the original. The biggies-banks with $250 billion or more in assets or $10 billion-plus in on-balance sheet exposure to foreign markets (or foreign subsidiaries with at least $10 billion on the books)[ii]-must have a 30-day buffer. The phase-in schedule for the biggest is also largely the same-the ratio must be 80% by January 1, 2015; 90% by January 1, 2016 and 100% from January 1, 2017 on. But the Fed wasn't entirely deaf to banks' requests for leniency, as there are some key differences:

  • The midsized banks get a one-year grace period. Their LCR starts phasing in January 1, 2016. They also get to report monthly instead of daily.
  • BUT, their required cushion was bumped to 30 days.[iii]
  • Banks with $700 billion or more get to report monthly for the first six months, giving them more room to "establish the required infrastructure" to report daily. The rest report monthly for the first year and a half.
  • "Collateralized deposits" (largely from state/local governments and trust companies), which by definition are, well, collateralized with certain assets, are exempt from the denominator. They're also exempt from the requirement to unwind "secured funding transactions" during times of stress-banks won't have to blow them out.
  • Investment grade non-financial corporate bonds traded over the counter now qualify as HQLA.
  • The HQLA universe of stocks was expanded from S&P 500 ex-Financials to include large-cap foreign firms (all with a 50% haircut).
  • Instead of basing the denominator on the "peak cumulative net outflow day" for the given month, which could overstate liquidity risk, banks can use a more nuanced formula that takes maturity of outstanding obligations into account.

In short, the major provisions have been known for a year (and hinted at for much longer), and the "surprises" are largely in banks' favor. No curveballs, no wrenches, and the "penalties" for noncompliance are still nice and fuzzy: The Fed knows banks sometimes have one-off liquidity needs, so they established a "flexible supervisory response" when a bank's LCR falls below the threshold. So nothing crazy like shutting down a bank just because it had a big withdrawal one day-extreme, but you never know. Overall, this is about as benign as regulatory changes can get-no nasty surprises, just clarity (a positive). Plus, the lengthy, transparent rule-writing process says a lot about the Fed's willingness to be open-kimono and not surprise banks with big changes.

It also gave banks a big head-start on buffer-building: Six of the biggest banks are already in compliance. The Fed estimates the rest have a combined $100 billion shortfall. That's tiny! It's also half the estimate from last October-and lending did not tank while banks were raising $100 billion in 11 months. That says a lot about their ability to get that last $100 billion in place by 2017 without much deleveraging or restraining lending-loan growth accelerated simultaneously. Retaining earnings should get them most (if not all) of the way there by full phase-in.

All that said, a few aspects of the LCR are up in the air-this "final" rule is still subject to another public comment window and potential revisions. Fed Governor Daniel Tarullo previewed one on Wednesday, saying the Fed would probably make room for some muni bonds in the final HQLA bucket. These were excluded from this version-much to banks' and local governments' chagrin-because the Fed didn't consider them liquid enough. But after much lobbying from banks, who like munis for their ultra-low default rate-and municipalities, who don't want their market being hollowed out or their borrowing costs jacked up-the Fed appears willing to classify the most liquid munis as HQLA. Another win! Tarullo also reiterated regulators are working on a separate LCR for US holding companies and branches of large foreign banks, which might have some ripple effects internationally, depending on how it's written (and how other countries receive it), but that's a topic for another day.

So between some forthcoming amendments, the FDIC and OCC votes and the last round of comments, we still don't know the exact final rule. But barring major negative changes, which don't seem likely based on what has transpired thus far, the LCR shouldn't ding banks or lending. They're already off and running, and that they have a wee bit more clarity than this time last week is a modest improvement.

[i] Don't ask us to explain the logic here. Please. Especially considering common sense would say smaller banks are more vulnerable to a run, considering the biggest banks already have the biggest buffers and depositors have the most confidence in the biggest banks.

[ii] This clarifies one of our questions about the proposal, which said the rule would apply to banks with "great international influence."

[iii] We'd like to think regulators noticed what we pointed out in footnote one, but the banks actually asked for this, saying 21 days is a weird timeframe that "does not align well with their existing systems and processes."

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.