Reed Smith discusses the Liquidity Coverage Ratio

We all know that liquids are both good and bad. We are supposed to drink on average eight glasses of water a day for good health. However, too much alcoholic intake will get us into trouble with the law. Now, the larger banking organizations are required to have a minimum amount of liquidity on their balance sheets fully in place by January 1, 2017.

Background The Federal Reserve Board (“Board”) at its September 3 open meeting finalized a minimum Liquidity Coverage Ratio rule (“LCR”) for covered bank holding companies (“BHCs”), savings and loan holding companies, and depositories. The action was taken consistent with section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring the Board to issue enhanced prudential standard rules. The Board’s action is generally consistent with the Basel III Revised Liquidity Framework’s LCR standard, but has a shorter transition period as outlined below. The rule will be issued jointly by the Board, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation. The liquidity rule is found at new Board Regulation WW.

Covered Companies In effect, the largest BHCs, those with total consolidated assets of $250 billion or more or total consolidated on-balance sheet foreign exposure of $10 billion or more (“covered companies”), and their subsidiary depository institutions with $10 billion or more of total consolidated assets, will become subject to the new LCR requirements. A simpler less stringent LCR requirement will apply to depository institution holding companies with $50 billion or more in total consolidated assets, but less than $250 billion and do not have substantial insurance or commercial operations (“modified LCR companies”). The LCR requirements will not apply to nonbank SIFIs or those depository institution holding companies with less than $50 billion in total assets. However, in the case of nonbank SIFIs, the Board either by rule or order will apply tailored enhanced liquidity standards to those companies.

High-Quality Liquid Assets The basic requirement is that a covered company must maintain a sufficient minimum amount of High-Quality Liquid Assets (“HQLA”) on its balance sheet to cover projected stressed cash outflows that might occur over a 30 calendar-day stress scenario. An HQLA is either cash or an asset that is readily convertible to cash. In the case of a modified LCR company, it needs to have a sufficient amount of HQLAs to cover stressed cash outflows over a 30 calendar-day stress scenario, reduced by 30 percent in recognition of its smaller size and generally less complex balance sheet.

LCR Calculation There is a transition period that is more accelerated than under the Basel III requirements, which become effective on January 1, 2019. Under the US LCR, the minimum LCR requirement for covered companies is 80 percent starting January 1, 2015, 90 percent as of January 1, 2016, and 100 percent fully compliant as of January 1, 2017.

Covered companies will also be given additional time to comply with the daily reporting requirements, and can calculate their LCR monthly during the transition period. The modified LCR companies (those between $50 billion and $250 billion in assets) will not be subject to the rule until January 1, 2016, and will have to calculate their LCR monthly, rather than daily.

With respect to the daily LCR calculation requirement, that requirement becomes effective July 1, 2015 only for the largest covered companies, that is those depository institutions with $700 billion or more in total consolidated assets or $10 trillion or more in assets under custody. Covered companies with total consolidated assets of $250 billion or more or $10 billion in total on-balance sheet foreign exposure and less than $700 billion in assets or $10 trillion or more in assets under custody, must start calculating their LCR on a daily basis on July 1, 2016. Prior to these dates the LCR is calculated by these covered companies at the end of each month, beginning January 1, 2015.

The estimate by Board staff is that if the LCR rule were fully effective at this time the shortfall is $100 billion out of a $2.5 trillion requirement for HQLA holdings at 100 percent. Approximately 70 percent of covered and modified companies currently meet the standard.

Municipal Securities There was considerable discussion at the open Board meeting about the treatment of municipal securities meeting the HQLA criteria. Comments and staff analysis was that certain municipal securities appear to be highly liquid, as opposed to being excluded under the proposed rule. The Board supported the staff recommendation that there be a proposal for public comment at a later date to include certain highly liquid municipal securities as HQLA.

Supervision and Enforcement Of particular significance is that the LCR is designed to deal with stressful situations. Accordingly, under those circumstances the Board and its staff recognize that in a period of stress the LCR will decline to below 100 percent and serve its purpose of enabling a covered company to not have to take such extra action steps as disposing of key or strategic businesses or would have to rely on the Board as the lender of last resort. In effect, the covered company will have recourse to its own assets and would be in a position to weather the storm without spreading its contagion.

In the case of a shortfall of HQLA the covered company is expected to notify its supervisor of the shortfall and develop a plan to come into compliance. The banking agencies at their discretion can take supervisory or enforcement actions to address noncompliance. However, in the event of a stress situation or where the liquidity resources are drawn down, the examination and supervisory process will become critical and clear lines of communication with the covered company necessary to work the latter through its difficult and challenging time. As opposed to where minimum capital requirements are not met and regulatory consequences are mandated, such as reducing or terminating dividends, or prohibiting share buybacks, the minimum LCR rule does not carry with it such a directive.

Some Implications A clear consequence of the liquidity requirement is that traditional bank deposits become more valuable, particularly those deposits that are deemed stable retail deposits. At the same time, it needs to be recognized that HQLA assets are generally lower earning assets. Thus, certain banks may feel the need to go further out on the risk curve. Finally, the new liquidity requirement might well drive up the cost of HQLA assets.

The full and original memorandum was published by Reed Smith LLP on September 4, 2014, and is available here.