The Federal Reserve Board and the FDIC finalized a rule on Wednesday to strengthen the liquidity positions of large financial institutions. The rule, called the Liquidity Coverage Ratio or LCR, was adopted under the international Basel III standards for banking. The Fed's new LCR rules, which go into effect, in part, January 1, 2015, are designed to ensure banks have sufficient funding to withstand a crisis. But Treasury Strategies, in an alert released Wednesday, believes it could be disruptive for corporate treasurers.
According to the Fed's press release on the LCR, "The rule will for the first time create a standardized minimum liquidity requirement for large and internationally active banking organizations. Each institution will be required to hold high quality, liquid assets (HQLA) such as central bank reserves and government and corporate debt that can be converted easily and quickly into cash in an amount equal to or greater than its projected cash outflows minus its projected cash inflows during a 30-day stress period. The ratio of the firm's liquid assets to its projected net cash outflow is its "liquidity coverage ratio," or LCR. The LCR will apply to all banking organizations with $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure and to these banking organizations' subsidiary depository institutions that have assets of $10 billion or more."
The final rule is quite similar to the proposed rule with a few key adjustments in response to public comments. "Those adjustments include changes to the range of corporate debt and equity securities included in HQLA, a phasing-in of daily calculation requirements, a revised approach to address maturity mismatch during a 30-day period, and changes in the stress period, calculation frequency, and implementation timeline for the bank holding companies and savings and loan companies subject to the modified LCR. The final rule does not apply to non-bank financial companies designated by the Financial Stability Oversight Council for enhanced supervision. Instead, the Federal Reserve Board plans to apply enhanced prudential liquidity standards to these institutions through a subsequently issued order or rule following an evaluation of the business model, capital structure, and risk profile of each designated nonbank financial company."
The rule is based on a liquidity standard agreed to by the Basel Committee on Banking Supervision. "The LCR will establish an enhanced prudential liquidity standard consistent with section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule is generally consistent with the Basel Committee's LCR standard, but is more stringent in certain areas, including a shorter transition period for implementation. The accelerated transition period reflects a desire to maintain the improved liquidity positions that U.S. institutions have established since the financial crisis, in part as a result of supervisory oversight by U.S. bank regulators. U.S. firms will be required to be fully compliant with the rule by January 1, 2017."
Tony Carfang, partner, Treasury Strategies Inc., provided some perspective Wednesday afternoon in a bulletin to his clients, corporate treasurers, saying the rules could impact their relationship with banks. He writes, "The LCR requires banks to segregate your demand deposits into "operational" and "non-operational" categories. Operational demand deposits are those arising from your day-to-day cash management and payments activities. Non-operational demand deposits are those in excess of your daily activities, or rate-sensitive deposits not subject to withdrawal limitations. In other words, non-operational deposits are those you can quickly move in the event of a problem at your bank."
He continues, "Under LCR, banks are free to use your operational deposits to make loans, leases and other general banking activities, much as they do today. Non-operational deposits can no longer be used in that manner. They must be backed only by high-quality, highly liquid assets, most likely US government securities. Thus, they are far less valuable to your banks and will be a drag on your banks' overall rates of return. Not all banks will be impacted in exactly the same way, however."
What does it mean for treasurers? "As banks look to attract operational demand deposits and discourage non-operational deposits, the economics of your banking relationship will change. We expect to see changes in bank service pricing and earnings credit rates, as well as entirely new deposit products. Depending on your banks, your cash flow volatility, service mix and absolute deposit levels, you may need to redesign your operational banking structure or reallocate your deposits."
Joe Abate, money market strategist at Barclays, commented on Fed Governor Tarullo's plans to tie supplemental capital requirements to a bank's reliance on short-term funding. He writes, "Fed Governor Tarullo noted that while requiring banks to hold more immediately accessible liquidity was a strong step in the right direction toward reducing systemic risk, additional work remains. Regulators "intend to incorporate reliance on short-term wholesale funding as a factor in setting the amounts of capital surcharges applicable to the most systemic banking organizations.""
He continues, "It is unclear how the Fed intends to proceed. For example, it might recommend an additional 1% capital surcharge based on the volume of wholesale funding a bank has under 30 days above a pre-determined limit. However, it is unclear what that "comfort threshold" might be. His statement refers explicitly to banking organizations in which, short-term wholesale funding has fallen sharply since the financial crisis. Indeed, 20% of their liabilities are funded in repo. By contrast, the institutions with the biggest repo financing as a share of their liabilities are not banks, but broker/dealers where repo still accounts for 50% of their liabilities. And the composition of their liability mix hasn't changed much in the past few years."
Abate adds, "Moreover, Fed Governor Tarullo mentioned that there is an international effort to "develop proposals for minimum collateral haircuts" in secured funding transactions. The Fed, among other regulators has long been concerned by the pro-cyclical nature of repo margins that were in a "race to the bottom" ahead of the financial crisis and then abruptly (and sharply) moved higher as the crisis unfolded. The Fed's concern centers particularly on the haircuts for non-government collateral. Both proposals -- capital surcharges based on the reliance on short-term funding and minimum secured funding haircuts -- have been mentioned in the past by Fed officials. Together with last month's repo conference, it seems the Fed is edging closer to releasing a proposal."
Finally, in other news, the European Central Bank cut the interest rate on its deposit facility by 10 basis points to -0.20%, further into negative territory than its already historic lows. (The ECB lowered the deposit rate to -0.10% on June 11, see Crane Data's News, "ECB Negative Deposit Rate Unlikely to Impact, Push Euro MFs Negative." Also, the main refinancing operations of the Eurosystem will be decreased by 10 basis points to 0.05% and the rate on the marginal lending facility will be decreased by 10 basis points to 0.30%, effective September 10, 2014.
In addition, ECB president Mario Draghi also announced plans to buy private sector assets. "The Governing Council decided to start purchasing non-financial private sector assets. The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme. This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme. Interventions under these programmes will start in October 2014."
