Last week the Fed proposed a new Notice of Proposed Rulemaking (NPR) that stipulates a standard for liquidity to be maintained by banks to weather any financial crisis. Liquidity refers to cash, government bonds and other high-quality assets that are readily convertible into cash.  The Fed’s benchmark is more rigorous than even that set by the Basel Committee.

Federal Reserve Fed

Fed’s liquidity benchmark

The large banks (those with more than $250B in assets) must have adequate liquidity to support operations for 30 days. Other banks (assets over $50B but less than $250B) need to cover for 21 days. Banks must fully comply with this requirement by January 1, 2017.

Citi Research analysts Josh Levin and Arjun Sharma examine the NPR in their paper “The Hot New Regulatory Requirement – Initial Thoughts on the Liquidity Coverage Ratio” of October 28, 2013.

The liquidity coverage ratio (LCR)

The LCR assumes considerable significance in view of the Fed’s estimate that banks are $200B short of meeting the threshold.

The LCR is computed by dividing [High Quality Liquid Assets (HQLA)] by [Stress Period Cash Outflow].

High quality liquid assets

These are computed as per the following table:

Category Assets Haircut Max. % of HQLA
Level 1 Reserves Held With the Fed and Other Central Banks/US Govt Guaranteed Securities Nil No Limit
Level 2A GSE Obligations 15% )   40%)
Level 2B Investment grade, publicly traded corporate debt of non-financial companies 50%

These are equal to [Projected Stress period cash outflow] less [Cash inflow] rates.

Critical points

  • There is an apparent conflict between the LCR and the Supplementary Leverage Ratio (SLR). The former places a premium on excess liquidity, while the latter frowns on it.
  • In LCR calculations, retail deposits would be preferable to corporate deposits, resulting in banks having to change their priorities and business models.
  • Asset / Liability mismatches have to be closely guarded against to ensure LCR compliance.
  • The discounting on the value of GSE Obligations (haircut) will affect pricing of mortgage-backed securities or agency debt.