How liquidity proposals could hit community banks

Since the onset of the decade’s financial turmoil, ensuring that banks have robust liquidity risk management practices has become a key priority for bank supervisors in the U.S. and abroad. In 2008, the Basel Committee on Bank Supervision (BCBS) issued a set of principles on liquidity risk management, intended to provide updated guidance for financial institutions and their supervisors. The Principles document is the basis for both enhanced qualitative liquidity standards in the United States—issued through guidance in 2010—and quantitative standards developed by the BCBS: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).  

In October of this year, the U.S. banking agencies issued a proposal to implement the LCR in this country. The comment period on the proposal closes Jan. 31, 2014.

The proposal, a more conservative approach than the Basel Committee’s LCR, would apply to internationally active bank holding companies with at least $250 billion in assets; their depository institution subsidiaries with $10 billion or more in assets; and certain nonbank financial companies designated as “systemically important” by the U.S. Financial Stability Oversight Council.

Additionally, the Federal Reserve Board, using its authority under Section 165 of the Dodd-Frank Act, independently proposed that a “modified LCR” be applied to non-internationally active bank holding companies with over $50 billion in assets. The Fed’s proposal relies on the same definitions for its ratio; however, the modified approach would shorten the assumed stress period and apply uniformly smaller run-off rates.

While the LCR is aimed at larger institutions, the standard, in conjunction with the myriad of new regulations aimed at banks of all sizes, would significantly impact the markets in which banks operate. This article provides an overview of the US LCR proposal and then discusses likely impacts on community banks.

Overview of U.S. LCR proposal

Here is the basic formula under the U.S. proposal:                                             

Liquidity Coverage Ratio =   High Quality Liquid Assets/Net Stressed Outflows, and must equal or exceed 100%.

The LCR is intended to ensure that a bank has a sufficient stock of unencumbered high quality liquid assets (HQLA)—specifically, sufficient to survive a 30-day stress period. The numerator is comprised of three levels: Level 1 and Levels 2A and 2B, with Level 1 securities being the most liquid. Level 1 assets must comprise at least 60% of the total stock of HQLA.  (See Table 1 for a listing of assets by category.)

Generally, under the proposal, the level of required HQLA is calibrated against net cash outflows, or total expected cash outflows, minus total expected cash inflows in the specified stress scenario.

The LCR stress is reflected in the denominator through run-off rates and assumptions regarding the rates at which (1) creditors will withdraw their funding and (2) the bank will receive income or other funds from counterparties.

For example, insured retail deposits are considered to be the least likely to leave a bank in periods of stress and, as such, are given the lowest assumed run-off rate. Conversely, financial institution deposits are considered to be among the most likely to leave a bank in a period of stress and are therefore given the highest run-off rate.

Inflows are calibrated around assumption about the need to maintain business (e.g., loan origination) and the ability of counterparties to return money owed to the banks.

The outflow amount is calculated by multiplying the run-off rate by the total amount outstanding; the inflow amount is calculated by multiplying the assumed inflow by the amount outstanding. The net of the two generally dictates the minimum required level of HQLA.

The LCR proposed in the U.S. has 12 outflows categories which cover a bank’s funding, including retail deposits, brokered deposits, wholesale funding, commitments, derivatives and secured financing transactions.  On the inflow side, there are certain exclusions and  a cap of 75%, relative to outflows, meant to insure that institutions meet the requirement via HQLA, not inflows. Inflows are recognized on contractual retail payments, unsecured wholesale funding, and secured financing transactions. (Table 2 shows selected outflows under the U.S. proposal.)  

Impact on community banks

The LCR proposal represents the first time a quantitative liquidity standard has been implemented in this country. Accordingly, there is significant uncertainty regarding how it will impact the banking industry, financial markets, and the U.S. economy.

The Federal Reserve has noted that banks covered by the LCR currently face a $200 billion HQLA shortfall. In order to come into compliance with the requirement, banks  must choose between the need to purchase HQLA, change their funding profiles, or reduce activities that are disadvantaged under the LCR—or to devise some combination thereof.

As a result, implementation of the LCR as proposed is likely to increase the cost of, among other things: bank funding, certain services provided by larger institutions, and lending in certain markets.

For example, the LCR favors retail deposits over other types of funding. One likely outcome, then, is that competition for these deposits will increase, making them more expensive for all banks.

Further, one of the intentions of the LCR is to reduce interconnectivity among financial institutions, so the cost of using Fed funds will likely increase. So will the cost of holding financial institution deposits for banks required to comply with the LCR—and by extension likely increase the cost of services, such as correspondent banking.

Moreover, there is widespread concern that the shortfall in HQLA and the narrow definition of HQLA will exacerbate the shortage of safe assets, making these securities more expensive for all investors. In fact, at the Federal Reserve’s Board meeting to consider the proposal, both Chairman Bernanke and Vice-Chairman Yellen (nominee to replace the chairman) expressed concern over this potential outcome.

The LCR could also potentially impact mortgage markets.

Under the proposal, securities issued by Fannie Mae, Freddie Mac, and other government sponsored enterprises (GSEs) are treated as less liquid than U.S. Treasuries or other securities backed by the full faith and credit of the U.S. Thus, institutions subject to the LCR will get less liquidity credit for these securities, which may have unintended consequences for the mortgage market.   

Additionally, supervisory and market expectations are likely to trickle down to even the smallest institutions.

For example, bank counterparties and investors may expect smaller banks to comply with the LCR, so they have greater insight into the institution’s liquidity position.  On the supervisory side, it is likely that examiners will use the LCR’s definitions and inherent biases when assessing even a smaller bank’s liquidity.

Going forward, there is significant uncertainty about the impact of the LCR on banks, their customers, and the markets in which they operate. The uncertainty is particularly acute when one looks at the cumulative impact of all the new regulations that banks face in the post Dodd-Frank Act environment.

About author Alison Touhey

Alison Touhey is Senior Regulatory Advisor in the Office of Regulatory Policy of the American Bankers Association, where she focuses on issues related to bank liquidity and international regulatory initiatives. Prior to joining ABA, Alison worked at FDIC in a variety of policy and research roles.  At FDIC, she participated in international efforts to develop liquidity standards under Basel III; developed liquidity and interest rate risk guidance; and monitored financial institutions and markets to identify emerging risks.  Alison began her career at ABA doing economic and policy analysis in the Office of the Chief Economist.