Tags: Fed | LCR | banks | liquidity

Fed Board Meets to Finalize Liquidity Rule

By    |   Monday, 15 September 2014 07:58 AM

The Federal Reserve Board of Governors, chaired by Janet Yellen, met Sept. 3 to adopt a new rule that is supposed to enhance liquidity requirements for large U.S. bank holding companies (more than $50 billion in assets) as part of the highly touted regulatory response to the 2008 episode of the ongoing, permanent financial crisis.

These meetings are not scintillating to watch, but they offer a window, however small and smudged, into the Fed's thinking about liquidity, which is a fundamental issue affecting the likelihood of yet another round of bailouts of "too big to fail" banks.

At a recent program of the Bipartisan Policy Center (BPC), former Treasury official Peter Fisher referred to the "liquidity illusion."

This writer's interpretation of the "liquidity illusion" is that financial innovators develop products designed for a particular set of market conditions, because they can, and as long as those conditions persist, there is demand for the products. However, inevitably, market conditions change along with the business cycle, and demand and liquidity will diminish and possibly disappear altogether, but at many financial institutions the assets will be carried at close to historical cost. Ultimately, the Fed may buy or guarantee these assets in order to avoid a so-called fire sale and recognition of losses that might call into question the solvency of too big to fail banks and other clients and constituents.

In her opening statement, Yellen explained that the rules being adopted by all of the financial regulators concern the liquidity coverage ratio (LCR) in light of the fact that in the 2008 crisis episode most of the largest financial institutions relied excessively on wholesale funding without a sufficient amount of high-quality liquid assets to withstand the stressed market environment without liquidity support from the government.

The Board also discussed the re-proposal of the swap margin rule in order to reduce systemic risk in the derivatives markets by moving standardized derivatives into central clearing and subjecting the remaining over-the-counter derivatives to margin requirements between the parties. The original proposal was issued back in 2011, and now it is being revised to reflect comments and international swap margin standards finalized in 2013, but will not take effect until the end of 2019.

After the opening remarks, the meeting was run by Daniel Tarullo, who declared that adoption of the LCR would establish, for the first time, liquidity regulation of the entire balance sheets of large banking organizations, implementing rules adopted by the Basel Committee on Banking Supervision "in response to the fact that liquidity squeezes were the 'agents of contagion'" in the 2008 episode. He pointed out, as discussed above, that during such a crisis "the distinction between liquidity and solvency can become increasingly blurred, as asset values tumble and uncertainty heightens." He attributed the lengthy time for consideration of the rules to the novelty of this proposal compared with the accompanying capital rules.

While the LCR relates to a 30-day stress period, another rule under consideration deals with a "net stable funding ratio" that would cover a one-year horizon. All of the proposals together are intended "to limit destabilizing funding runs and credit contraction while not creating incentives for firms to hoard liquidity in periods of stress."

Tarullo warned that some risks remain unaddressed, including "the risks associated with even the largest matched repo books." He also referred to proposals being discussed by international regulators to set standards for haircuts on securities financing transactions. Finally, a tweak to the rule is in the works when the regulators figure out how much weight to give to municipal bonds as "high-quality liquid assets."

During the discussion, staff emphasized that in a crisis circumstance, it would be OK for banks to fall below the LCR while their supervisors figure out how to deal with the circumstance.

(Archived video can be found here. The press release from the Fed can be found here.)

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The Federal Reserve Board of Governors met Sept. 3 to adopt a new rule that is supposed to enhance liquidity requirements for large U.S. bank holding companies as part of the highly touted regulatory response to the 2008 episode of the ongoing, permanent financial crisis.
Fed, LCR, banks, liquidity
Monday, 15 September 2014 07:58 AM
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