Bank Liquidity Requirements: Federal Reserve Proposes Inclusion of Certain U.S. Municipal Securities as High-Quality Liquid Assets for Purposes of the Liquidity Coverage Ratio

Sullivan & Cromwell LLP - May 26, 2015

On Thursday, May 21, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a notice of proposed rulemaking (the “Proposal”) that would amend the final rule implementing a liquidity coverage ratio (“LCR”) requirement (the “Final LCR Rule”), jointly adopted last September by the Federal Reserve, the Office of the Comptroller of the Currency (“OCC”), and the Federal Deposit Insurance Corporation (“FDIC”), to treat certain general obligation state and municipal bonds as high-quality liquid assets (“HQLA”).  Unlike the Final Rule, the OCC and FDIC did not join the Federal Reserve in issuing the Proposal. Accordingly, the Proposal would apply only to banking institutions regulated by the Federal Reserve that are subject to the LCR, absent further action by the other agencies.  The Proposal would allow these entities to treat general obligation securities of a public sector entity (“PSE”) as level 2B liquid assets, provided that the securities generally satisfy the same criteria as corporate debt securities that are classified as level 2B liquid assets, as well as certain other restrictions and limitations applicable only to these assets as described further below.  Comments on the Proposal are due by July 24, 2015.

Although the agencies originally declined to include U.S. municipal securities as HQLA in the Final Rule, expressing concern that banking institutions would be limited in their ability to rapidly monetize municipal securities during a period of significant stress, the Federal Reserve at the time indicated a willingness to continue to study the question.  In support of the Proposal, the Federal Reserve cites commenters’ contentions that some U.S. municipal securities trade more often and in greater volumes than some corporate debt included as HQLA and that exclusion of U.S. municipal securities from HQLA could lead to higher funding costs for U.S. municipalities, negatively impacting local economies and infrastructure.  If the other banking agencies choose not to modify the HQLA treatment of municipal securities held by entities subject to their supervision – that is, national banks and certain state chartered banks – it could substantially limit the practical usefulness of the Proposal for banking organizations, particularly those that principally hold municipal securities in their national bank subsidiaries.