On April 11, 2016, the Federal Reserve Board published a final rule that allows banking organizations under its jurisdiction the flexibility to include some state and municipal securities in meeting certain of its liquidity requirements. It is effective July 1, 2015.

In September 2014, the US federal banking regulators (the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC)) finalized Liquidity Coverage Ratio (LCR) rules, based on recommendations issued by the Basel Committee of the Bank for International Settlements, which issues international standards for banks. The LCR requires that certain large banking organizations maintain sufficient high quality liquid assets (HQLA) to cover cash outflows during a 30 day liquidity stress scenario that includes certain levels of deposit run-off or a reduction in wholesale funding capacity. HQLA include cash and, among other instruments, securities issued or unconditionally guaranteed by the US Treasury, and certain securities issued by US-government sponsored enterprises, but only at 85% of the dollar amount of the assets.

Many commenters on the proposed LCR rule raised concerns that US state and municipal debt securities were not considered as HQLA, even though their liquidity profile met or exceeded that of other assets classified as HQLA in the final LCR rule. On May 28, 2015, the Federal Reserve Board published a proposed rule to allow general obligations issued or guaranteed by a US public sector entity (i.e., a state or local authority), referred to as “municipal securities” in the Federal Reserve Board’s commentaries issued with the proposed and final rules, to be treated as HQLA under the LCR rule, subject to certain qualifications and limitations.

Final rule applicability

The final rule is applicable only to banking organizations under the jurisdiction of the Federal Reserve Board, which includes large bank holding companies (and certain of their consolidated bank subsidiaries), savings and loan holding companies and state-chartered banks that are member banks of the Federal Reserve System (“covered banking organizations”). The final rule would not apply to large banking organizations subject to the jurisdiction of the OCC (national banks and federal savings associations) or the FDIC (state-chartered non-Federal Reserve Board member banks and state-chartered savings associations).

Final rule requirements

Under the final rule, covered banking organizations can use as so-called “Level 2B” assets (an LCR category that currently includes investment grade corporate debt and equities) certain municipal securities (those backed by the full faith and credit of a US state or municipality) but only at 50 percent of the dollar amount of the asset. Level 2B assets can account for a maximum of 15 percent of the entire HQLA amount. Among other criteria, these municipal securities will have to be liquid, readily marketable and meet other criteria consistent with the corporate debt securities currently allowed as Level 2B assets.

In addition, under the final rule and adopted as proposed, to be eligible Level 2B assets, these municipal securities must be “investment grade” as defined in OCC regulations (which requires an assessment of the capacity of the issuer of the security to meet its financial commitments) and the issuer’s obligations must have a proven record as a reliable source of liquidity in repurchase or sales markets during a period of significant stress (as set forth in the final regulation). Also adopted as proposed were additional limitations on the amount of municipal securities that could count as HQLA, based on the average daily trading volume of municipal securities issued by a particular US municipal issuer, and on a percentage of the institution’s total HQLA amount.

Changes from the proposal

There were a few changes from the proposed rule. The proposed rule would have disallowed obligations of a “financial sector entity” (such as an investment company or other regulated financial company) or a consolidated subsidiary of such an entity, which would be consistent with the current treatment of corporate debt securities used as Level 2B assets. However, in response to the comments, the Federal Reserve Board is allowing use of municipal securities as Level 2B assets that are insured by a bond insurer, so long as the underlying municipal security would qualify as HQLA without the insurance. In addition, the Federal Reserve Board eliminated the proposed requirement that limited the amount of municipal securities used to meet the Level 2B assets to 25 percent of the total amount outstanding of US general obligation municipal securities with the same CUSIP number.

See our previous posts on the LCR final rules and the proposal to allow state and municipal bonds being eligible for the LCR.

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