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From Banking and Finance Law Daily, April 1, 2016

Fed permits using state, municipal securities to satisfy liquidity requirements

By Richard A. Roth, J.D.

The Federal Reserve Board has amended its liquidity coverage ratio regulation to allow covered financial institutions to include some general obligation securities issued by U.S. state and municipal governments in their required high quality liquid assets. The amendment to Reg. WW—Liquidity Risk Measurement Standards (12 CFR Part 249) will allow financial institutions to include the securities, up to specified maximum levels, if they satisfy the same liquidity criteria that apply to corporate debt securities, the Fed says.

The LCR rules, adopted in September 2014, require each covered holding company, bank, and systemically important nonbank financial institution to hold high-quality, liquid assets—assets that can be converted easily and quickly into cash—in an amount at least equal to the institution’s projected net cash outflow during a 30-day stress period. The rules apply to banking organizations that have $250 billion or more in total assets or $10 billion or more in on-balance sheet foreign exposures, and to their subsidiaries that have assets of $10 billion. Smaller bank and thrift holding companies that have $50 billion in total assets are covered by a less strict liquidity coverage ratio requirement (see Banking and Finance Law Daily, Sept. 3, 2014).

The original rule did not include state or municipal securities within the definition of HQLA, which gave rise to considerable criticism and the introduction of at least one bill in Congress. The Fed subsequently proposed an amendment to Reg. WW to allow these securities to be included (see Banking and Finance Law Daily, May 21, 2015).

Broader HQLA definition. According to the Fed, its subsequent analysis showed that some state or municipal securities have liquidity characteristics that are similar to those of corporate debt securities that qualify for HQLA treatment. However, these securities will be considered Level 2B liquid assets, which are the lowest of the three levels of HQLA. Level 2B securities generally are subject to a 50-percent haircut and can comprise no more than 15 percent of a financial institution’s HQLA amount.

There is a limit on how much of a single government entity issuer’s securities can be included in any financial institution’s HQLA calculations. Also, no more than 5 percent of an institution’s HQLA can be state or municipal securities.

To qualify as HQLA, a state or municipal security must be:

  • a general obligation of a public sector entity that is backed by the full faith and credit of the issuer;
  • an investment grade security; and
  • issued by a public sector entity whose obligations have “a proven track record as a reliable source of liquidity in repurchase or sales markets during a period of significant stress.”

Revenue bonds cannot be considered HQLA. Obligations of a financial sector entity or a consolidated subsidiary of such an entity are ineligible, the Fed says, in order to exclude assets that are valued based on guarantees by such an entity. However, in a change from the proposed amendments, a security that would be eligible for HQLA consideration on its own will not be rendered ineligible due to such a guarantee.

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