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From Banking and Finance Law Daily, October 24, 2013

Fed approves proposed liquidity coverage ratio

By John M. Pachkowski, J.D.

Following its Oct. 24, 2013, open meeting (webcast), the Federal Reserve Board has approved a proposed rulemaking that would create a standardized minimum liquidity requirement for certain banking organizations and systemically important, non-bank financial companies designated by the Financial Stability Oversight Council.

Comments on the proposal will be received through Jan. 14, 2014.

The proposed “liquidity coverage ratio,” or LCR, would require each institution 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 short-term stress period. The classes of HQLA would be known as “Level 1 assets,” “Level 2A liquid assets,” and “Level 2B liquid assets.”

Covered companies. The proposed LCR would apply to all internationally active banking organizations—generally, those with $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure—and to systemically important, non-bank financial institutions. The proposal also would apply a less stringent, modified LCR to bank holding companies and savings and loan holding companies that are not internationally active, but have more than $50 billion in total assets. Bank holding companies and savings and loan holding companies with substantial insurance subsidiaries and non-bank, systemically important financial institutions with substantial insurance operations are not covered by the proposal.

Basel standards. The Fed’s LCR proposal is based on a standard agreed to by the Basel Committee on Banking Supervision and would also establish an enhanced prudential liquidity standard consistent with section 165 of the Dodd-Frank Act.

The Basel III liquidity standards also includes a Net Stable Funding Ratio (NSFR) that is designed to promote resilience over a one-year time horizon by creating additional incentives for banking organizations and other financial companies that would be subject to the standard to fund their activities with more stable sources and encouraging a sustainable maturity structure of assets and liabilities. Currently, the NSFR is in an international observation period as the Fed works with other Basel Committee members and the banking industry to gather data and study the impact of the proposed NSFR standard on the banking system. In a memorandum, Fed staff noted that a NSFR rule would be proposed well in advance of the 2018 global implementation date.

Accelerated compliance. Although the proposal is based on the Basel Committee standard, it is more stringent in several areas, including the range of assets that will qualify as HQLA and the assumed rate of outflows of certain kinds of funding. In addition, the proposed transition period is shorter than that included in the Basel agreement. The Basel Committee standard envisioned full compliance by January 2019, while full compliance with the Fed’s proposal would be January 2017. The Fed’s staff noted that 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 the Fed and other U.S. bank regulators.

Resilient and safer system. Commenting on the proposal, Fed Chairman Ben S. Bernanke said, “Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system. The proposed rule would, for the first time in the United States, put in place a quantitative liquidity requirement that would foster a more resilient and safer financial system in conjunction with other reforms.”

Weakened memories. Fed Governor Daniel K. Tarullo noted, “Since financial crises usually begin with a liquidity squeeze that further weakens the capital position of vulnerable firms, it is essential that we adopt liquidity regulations to complement the stronger capital requirements, stress testing, and other enhancements to the regulatory system we have been putting in place over the past several years.” He added, “This rule would help ensure that the liquidity positions of our banking firms do not weaken as memories of the crisis fade.”

The proposal will be published in the Federal Register jointly with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency after those each agency has completed its internal review and approval procedures.

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