The US Federal Reserve’s proposals to implement the liquidity coverage ratio component of Basel III involves hitting their deadline sooner than Basel's recommendations and tighter definitions of liquid assets.

What’s happening?

In an open meeting held at the end of October 2013, the US Federal Reserve presented draft proposals to implement the liquidity coverage ratio (LCR). This is one of the key components of the Basel III global bank regulation accords. The proposals include 76 questions, with a deadline of January 31, 2014 for responses from the market.

What is special about it?

Crucially, the US LCR would apply not just to internationally active banks – as recommended by the Basel Committee on Banking Supervision (BCBS) – but also to any domestic US bank with assets totalling more than $50bn. The requirements for these smaller banks would be diluted, including a liquidity stress scenario of 21 days rather than 30 days for the systemic banks.

The US also wants to move faster than Basel. Banks will need to reach a 100% LCR by 2017, two years earlier than the deadline for the application of Basel III. The list of assets eligible to be held as part of a bank’s liquidity buffer – known as high-quality liquid assets (HQLA) also differs significantly. HQLAs fall into three categories – level 1 (the most liquid) and levels 2A and 2B. Level 2 assets can only be included in the liquidity buffer with significant valuation haircuts. Several types of assets that are eligible HQLAs under the EU’s Capital Requirements Directive have been excluded by the Fed, such as private-label mortgage-backed securities. And bonds issued by US municipalities, a vast market in the US, do not count toward the LCR at all.

Finally, the definition of the 30-day period itself appears to be more rigorous than the rules proposed by the BCBS. Under Basel III, banks must hold sufficient liquid assets to cover 100% of outflows over the whole of any 30-day stress period. Under the Fed draft, compliance is also based on holding enough liquidity to meet the largest single day of outflows during that 30-day period.

What do the regulators say?

Rage-ometer

The Fed’s proposal says the need to comply on the largest single day of outflows is necessary because “it takes into account potential maturity mismatches between a covered company’s outflows and inflows, that is, the risk that a covered company could have a substantial amount of contractual inflows late in a 30-day stress period while also having substantial outflows early in the same period.”

During an open meeting on the proposals, Fed staff member David Emmel set out the results of a quantitative impact study among some of the largest US banks. He felt these demonstrated that the implementation of LCR was manageable for the banks.

“A substantial number of firms are relatively close to the 100% requirement and several are over the actual requirement. The amount of HQLA that firms are short is roughly $200bn or 10% of the total HQLA requirement. I would also state that through the observation period, we have observed firms make substantially larger gains than the $200bn that remains to become in full compliance,” says Mr Emmel.

What do the banks say?

The impact of the US LCR is expected to be uneven. Mario Onorato, balance sheet practice leader at IBM, which provides banks with balance sheet management technology, says that globally active banking groups with large financial market activities are already managing liquidity not just on a daily basis, but even on an intraday basis. This is necessary to meet cash calls at specific times of day from clearing and settlement systems such as continuous linked settlement in the foreign exchange markets.

“Those individual intraday obligations can sometimes be five times the size of the liquidity buffer, and are almost always greater than the end-of-day liquidity needs. Intraday liquidity is not prescribed precisely by the Basel Committee, but banks are required to monitor it and to report the results of that monitoring to the regulators,” says Mr Onorato.

Will investors lead the way?

Consequently, the real challenge will be for the domestic banks with assets totalling more than $50bn, whose current liquidity management practices are less sophisticated. The decision to implement the US LCR faster than the Basel timetable makes the adaptation process even more difficult.

“The timetable for regional banks is very truncated and it is not clear yet how much flexibility there might be on that. But we have been hearing from our members that their investors are already beginning to expect banks to discuss their LCRs, so the differences between the US and Basel schedules may become a moot point,” says Alison Touhey, senior regulatory advisor at the American Bankers Association.

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