Basel III Liquidity Framework: Federal Reserve Issues Basel III Liquidity Coverage Ratio Proposal for Large U.S. Banks

Sullivan & Cromwell LLP - October 29, 2013
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On Thursday, October 24, the Board of Governors of the Federal Reserve System (the “FRB”) approved for publication a notice of proposed rulemaking (the “Proposal”) to implement a quantitative liquidity coverage ratio (“LCR”) requirement for certain large domestic bank holding companies, savings and loan holding companies, depository institutions and nonbank financial companies designated by the Financial Stability Oversight Council. The Proposal is a joint rulemaking of the FRB, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The LCR is intended to ensure that these banking organizations hold sufficient stocks of “high quality liquid assets” (“HQLA”) to survive an acute 30 day liquidity stress scenario.

In general, the Proposal follows the international blueprint laid out by the LCR framework (the “Basel III LCR”) finalized by the Basel Committee on Banking Supervision (the “Basel Committee”) in January 2013. In a number of significant respects, however, the Proposal is more restrictive than the Basel III LCR (which the FRB refers to as “super-equivalence”), in particular for banking organizations with $250 billion or more in consolidated assets or $10 billion or more in foreign exposures, which is the same standard applied for identifying “advanced approaches” banking organizations under risk-based capital rules. Aspects of the Proposal that differ from the Basel III LCR include:

  • Banking organizations would be required to comply with the LCR on an accelerated schedule, maintaining a minimum LCR of 80% by January 1, 2015 and 100% by January 1, 2017. Under the Basel III LCR, by contrast, banking organizations would not be required to maintain a 100% LCR until January 1, 2019. While citing the improved liquidity of U.S. banks as a rationale for the accelerated timeline, FRB representatives nonetheless estimated the current industry LCR shortfall at about $200 billion out of $2 trillion in total required HQLA.
  • The Proposal would separately apply the LCR framework to advanced approaches banking organizations’ depository institution subsidiaries with more than $10 billion in consolidated assets.
  • Banking organizations would be more limited in their ability to include corporate debt securities as part of their stocks of HQLA. Corporate debt securities are only includible as Level 2B assets subject to a 50% haircut – as opposed to Level 2A subject to a 15% haircut under the Basel III LCR. In addition, the Proposal excludes covered bonds and securities issued by any state, local authority or other government subdivision below the national level (including U.S. states and municipalities) from the stock of HQLA. Finally, under the Proposal, Level 2B liquid assets would not include residential mortgage-backed securities in any amount, whereas the Basel III LCR generally permits their inclusion in Level 2B liquid assets subject to a 25% haircut.
  • Whereas the Basel III LCR requires HQLA to be at least equal to net cash outflows at the end of the 30 day stress period, the Proposal would require a large banking organization’s HQLA to be at least equal to net cash outflows on every day of the 30 day stress period. This is intended to guard against maturity mismatches within the 30 day stress period.
  • Finally, as described in more detail below, the Proposal makes various other changes to the LCR calculations, many of which represent incrementally more conservative (that is, more pessimistic) assumptions about the liquidity of assets and cash outflows during a period of liquidity stress. Among other things, where the Basel III LCR measures cash outflows for purposes of the LCR’s denominator only with reference to deposits and other claims that are payable upon demand or come due within 30 days of the calculation date, the Proposal measures outflows (and, accordingly, applies “run-off factors”) to certain instruments and claims irrespective of their maturities, including all retail deposits (for example, retail certificates of deposit maturing more than 30 days after the calculation date) and certain brokered deposits.

The Proposal also would introduce a modified LCR standard for bank holding companies and savings and loan holding companies with at least $50 billion in total consolidated assets that are not advanced approaches banking organizations. This modified LCR would implement a 21 calendar day (rather than 30 calendar day) stress scenario for modified LCR companies. In addition, unlike under the LCR applicable to advanced approaches banking organizations, total cash outflow for the modified LCR would not be based on the highest cumulative outflow day during the stress period but instead would be calculated as total cash outflows over a 21 calendar day stress period. In addition, the modified LCR would use inflow and outflow rate assumptions generally equal to 70% of those used for purposes of the LCR for advanced approaches banking organizations. The modified LCR would not separately apply to the depository institution or other subsidiaries of non-advanced approaches covered banking organizations.

While endorsing an LCR that, in certain respects, is more stringent than the Basel III LCR, the FRB nonetheless emphasized that the LCR is only one part of an evolving field of liquidity regulation. The FRB noted that the LCR is meant to be complementary to the FRB’s regime of enhanced prudential supervision under Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act – which would already require company run liquidity stress testing and contingency planning – and reiterated the FRB’s commitment to adopting a version of the longer-term net stable funding ratio currently under review by the Basel Committee. Finally, at the FRB meeting to approve the Proposal the FRB governors highlighted other forthcoming “macroprudential” initiatives focused on risks associated with short-term wholesale funding and securities financing transactions. FRB Governor Daniel K. Tarullo, echoing other remarks that he has made recently, noted that risks presented by short-term wholesale funding are “as much or more macroprudential as they are firm-specific, whereas the LCR has a principally microprudential focus, focused as it is on the liquidity of each firm individually.” Governor Tarullo concluded by stressing that “among [the FRB’s] highest remaining priorities should be more macroprudentially informed regulatory measures to address the tail risk event of a generalized liquidity stress by forcing some internalization of the systemic costs of this form of financial intermediation.”

Comments on the Proposal are due by January 31, 2014.