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1 1 (January 10, 2018)

handle is hein.crs/govcgzp0001 and id is 1 raw text is: 01;0i E.$~ & January 10, 2018 Financial Reform: Muni Bonds and the LCR This In Focus reviews legislative proposals to require regulators to allow large banks to use municipal (muni) bonds to meet the requirements of the Liquidity Coverage Ratio (LCR). Municipal bonds are debt securities issued by state and local governments or public entities to finance government spending and public activities. Certain bank regulators do not allow them to be used to meet the LCR, which may act as a disincentive for large banks to hold them compared to eligible assets. Whether municipal bonds are liquid enough to qualify under the LCR is a contentious issue, with possible implications for financial stability and the ability of states and localities to raise funds. Liquidity~ (2 xvera&e Ratik Because of liquidity mismatch (e.g., banks fund long- term, illiquid loans with deposits that can be withdrawn on demand), banks are inherently prone to liquidity crises a temporary loss of access to funding can cause an otherwise healthy bank to fail. In response to acute liquidity shortages and asset fire sales during the 2007-2009 financial crisis, the banking regulators-the Federal Reserve (Fed), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) issued a final rule in 2014 implementing the LCR. The LCR is part of bank liquidity standards required for large banks by Basel III (internationally negotiated bank regulatory standards) and the Dodd-Frank Act (P.L. 111-203). The LCR aims to reduce the liquidity mismatch by requiring banks to hold more liquid assets. The LCR applies to two sets of banks. A more stringent version applies to the largest, internationally active banks those with at least $250 billion in assets and $10 billion in on-balance-sheet foreign exposure. A less stringent version applies to depositories with $50 billion to $250 billion in assets, except for those with significant insurance or commercial operations. As of 2017, over 30 institutions must comply with the LCR. At this time, the rule does not apply to credit unions, community banks, foreign banks operating in the United States, or nonbank financial firms. The LCR requires banks to hold enough high-quality liquid assets (HQLA) to be able to meet possible net cash outflows over 30 days in a hypothetical market stress scenario in which creditors are withdrawing substantial amounts of funds. An asset can qualify as a HQLA if it is (1) less risky, (2) has a high likelihood of remaining liquid during a crisis, (3) is actively traded in secondary markets, (4) is not subject to excessive price volatility, (5) can be easily valued, and (6) is accepted by the Fed as collateral for loans. The assets that regulators have approved as HQLA include bank reserves, U.S. Treasury securities, certain securities issued by foreign governments and companies, securities issued by U.S. government-sponsored enterprises (GSEs), certain investment-grade corporate debt securities, and equities in the Russell 1000 Index. Different types of assets are relatively more or less liquid. In the LCR, assets eligible as HQLA are assigned to one of three categories (Levels 1, 2A, and 2B). Assets assigned to the most liquid category (Level 1) receive more credit toward meeting the requirements, and assets in the least liquid category (Level 2B) receive less credit (see Table 1). For example, 50% of the value of a Level 2B asset counts toward the HQLA, and Level 2B assets can make up 15% of total HQLA, at most. Table I. HQLA Requirements % of Asset Value Counting Max % of Total Asset Level Toward HQLA HQLA Level I 100% 100% Level 2A 85% n/a Level 2B 50% 15% Level 2A+2B n/a 40% Source: CRS based on Liquidity Coverage Ratio rule. Municipal Bonds in the LCR. The Fed currently allows the depository institutions and holding companies it regulates to count a limited amount of municipal securities as Level 2B assets. The FDIC and OCC do not allow the depositories they regulate to count municipal securities as HQLAs. As a result, many banks subject to the LCR must comply with the Fed's version of the LCR at the holding company level and the OCC/FDIC's version of the rule at the depository subsidiary level. In the 2014 final joint rule, municipal bonds did not qualify as HQLA to meet the LCR. However, a subsequent 2016 final rule issued only by the Fed changed its treatment of municipal securities. According to the Fed, The final rule allows investment-grade, U.S. general obligation state and municipal securities to be counted as HQLA up to certain levels if they meet the same liquidity criteria that currently apply to corporate debt securities. The limits on the amount of a state's or municipality's securities that could qualify are based on the liquidity characteristics of the securities. In the Fed's rule, the amount of municipal debt eligible to be included as HQLA is subject to various limitations, including an overall cap of 5% of a bank's total HQLA. The Fed requires banks to demonstrate that a security has a proven record as a reliable source of liquidity in repurchase K~:> p\w -- , gn'a', goo mppm qq\ a , q 'S I 11LIANJILiN,

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