Municipal bonds won’t be treated as High Quality Liquid Assets (HQLA) if the current formulation for new banking capital requirements goes into effect, but many banks and financial analysts are arguing that this is unreasonable. The goal of having HQLA on hand is to ensure that banks remain solvent whenever the next crisis hits, and Citi analyst George Friedlander thinks munis fit the bill.

Municipal bonds

Municipal bonds given HQLA status

“Municipal bonds compare favorably with many of the sectors that were given status as HQLA, including corporate bonds, S&P 500 stocks, and foreign sovereign debt,” writes Friedlander. “We believe that an extremely strong case can be made that municipal bonds compare favorably with many of these other sectors, and thus also warrant inclusion as HQLA.”

The method for determining which assets qualify as HQLA doesn’t take credit ratings into account. “The problem with this approach,” writes Friedlaner, “is that credit strength matters greatly in terms of the resilience of a given bank asset during potential periods of market stress, and that omitting this factor eliminates a key measure of the potential resilience of bank holdings.”

Credit strength should be a key criterion for HQLA

Friedlander equates credit ratings with credit strength, which seems a bit dangerous in the aftermath of the financial crisis, but he’s certainly right that credit strength shouldn’t be ignored. During a crisis there is a flight to quality that benefits strong assets at least as much as it punishes weak ones, and while no one is arguing that municipal bonds will hold up as well as sovereign bonds, they are at least comparable with corporate bonds. But it’s the inclusion of S&P 500 equities that really puts some perspective on the matter: equities are certainly liquid, but they don’t hold up well during a crisis.

“Strongly rated municipals present a substantially lower risk of severe price erosion during a substantial economic or capital market crisis than equities do,” writes Friedlander.

Treating munis as HQLA is in line with international norms

Friedlander has previously argued that the inclusion of municipal bonds would also be in line with international standards, and in line with existing rules to treat foreign state debt as HQLA. The Municipal bond market has already caught one regulatory break recently when municipal bonds were exempted from the Volcker Rule that prohibits proprietary trading, and a second big win would likely give the market a boost in demand to start off next year.