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Proposed Liquidity Rule for Banks: Likely Impact on Liquidity Management, Profitability and Compliance

Posted by Val Srinivas, Banking & Securities research leader, Deloitte Services LP, on November 19, 2013

Basel III rollout is quickly gathering pace in the US. Just a few months ago, banking regulators finalized the capital rules, which also included a higher supplementary leverage ratio (SLR) for the systemically important banks.

And more recently, on October 24, the Federal Reserve, the FDIC and the OCC, jointly released the Notice of Proposed Rulemaking on the Liquidity Coverage Ratio (LCR). (The Net Stable Funding Ratio is expected to be next on the agenda.1 )

The final liquidity rule, to be implemented in January 2015, may be different from the proposed rule, which has a 90-day comment period until January 31, 2014. But in reflecting on the proposal, I couldn’t help but wonder about the likely consequences on banks’ liquidity management strategies and compliance programs.

I will get to this point in a bit. But for those who are unfamiliar with the proposed liquidity rule, here is a quick summary.

The general consensus, thus far, is that the proposed liquidity standards are more “stringent” than the Basel III framework.2

  • First, the calculation of LCR is stricter, with even higher expectations (longer stress period and a more stringent outflow test) for those institutions with $250 billion or more in total assets or those with $10 billion or more in foreign exposures. The numerator in the LCR — i.e., eligible high quality liquid assets (HQLA) — is more narrowly defined, excluding assets like covered bonds, private label mortgage-backed securities and even municipal bonds. GSE securities (Fannie and Freddie MBS) would only be included in the Level 2A category and with a 15 percent haircut. 
  • Second, the denominator — i.e., total net cash outflows — is to be calculated on a daily basis, as opposed to the end of the 30-calendar day stress period laid out in the Basel LCR framework.
  • Third, the implementation timeline is more aggressive, with the expectation of 80 percent compliance by January 1, 2015, and full compliance by January 1, 2017, two years ahead of the Basel schedule.

All this means that there would be a $200 billion HQLA liquidity shortfall among the affected institutions by the time proposed LCR is in full compliance by 2017.3 

But the good news, based on the Federal Reserve’s own quantitative impact study, is that many institutions are close to the 100-percent LCR figure already and several are in fact “over the actual requirement.” 4 

This is likely the result of existing regulations that have already forced the largest institutions to hold higher levels of liquidity. For instance, banks already provide liquidity information to regulators through the “fourth-generation” daily liquidity reporting on assets, liabilities and potential claims.

Reverting back to the point I raised earlier, what are the likely consequences of LCR on the affected banks?

First, it appears the more narrow definition of HQLA and the daily liquidity requirement will likely make liquidity management more challenging. High quality collateral will be in greater demand by everybody, possibly affecting their pricing. And the daily liquidity calibration will likely force banks to reduce the volatility in their cash-flow sensitive businesses in order to remain within the liquidity parameters.

Second, it might negatively impact profitability of certain business lines dependent on short-term wholesale funding markets. 5 This is probably more the case with systemically important banks with big broker-dealer operations, which also have to contend with other regulations such as the supplementary leverage ratio (SLR) and resolution planning, among other rules.

Third, it will also force institutions to further rethink their funding mix, especially the way funding is done in the interbank lending and repo markets. There is also likely to be a greater reliance on more stable funding sources, such as bank deposits, possibly increasing the competition for these funds. 6 

Fourth, from a bank compliance perspective, it could further complicate their efforts and add to the burden they already face with existing regulations. 

Lastly, it may further put the US banks at a competitive disadvantage, if the Basel rules are not applied uniformly around the world.

Some of these consequences are likely to be intentional. Regulators are concerned about financial stability and want to ensure that banks adopt prudent approaches to capital and liquidity management.

What is your opinion? Do you think the proposed LCR rule from the US regulators will result in the consequences noted above?

1 Charles Horn, “Federal Reserve Proposes Stricter Banking Liquidity Rules.” Mondaq Business Briefing, November 3, 2013
2 Douwe Miedema and Emily Stephenson, “U.S. Sets bank liquidity plan, says tougher than Basel,” Reuters, October 24, 2013; Robert Soukup, “Liquidity rule stricter than expected; loaded with complexity,” SNL Blogs, SNL Financial, October 30, 2013
3 Federal Reserve, “Transcript of the Open Board Meeting,” October 24, 2013
4 Ibid
5 Peter Eavis, “Fed proposes rule to help big banks stay liquid; Bank of England makes similar bid to keep cash flowing during crises,” Dealbook, The New York Times, October 24, 2013
6 Ryan Tracy and Michael R. Cittenden, “Fed Acts to Bolster Safety Net at Banks,” The Wall Street Journal, October 24, 2013

As used in this document, “Deloitte” means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

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