In a market crash, the large banks could be forced to become more liquid, but does this change to policy address the real issue?

New guidelines for large banks liquidity

U.S. bank regulators are voting on new guidelines that would force the large banks to have liquid assets to fund operations for 30 days should the market crash again as it did in 2008. Large U.S. banks are currently $100 billion short of the safe asset requirement if the rule under consideration is enacted.

During the 2008 market crash, 12 of the 13 large banks faced an immediate need for cash as they were set to fail, forcing the government to quickly act — some say in haste — to stem what could have destroyed the world economy.

large banks Private Banks Richard Pzena

The Federal Deposit Insurance Corporation and the Federal Reserve are currently voting to require the largest U.S. banks hold more easily tradeable assets, according to a report in MarketWatch.

Market freeze up could cause major problems for large banks

If markets were to “freeze up” again, particularly in lightly traded over the counter debt instruments and derivatives products, it could cause major problems for the large banks and require another government bailout.

The final rule, which has been under consideration for close to a year, makes several notable changes from the draft proposal outlined in October of 2013. Banks ultimately will be able to hold liquid municipal debt for which municipalities had lobbied, according to the report. Criteria for defining appropriate liquidity and other measures of security are still to be developed by the regulators. Large banks can also hold stocks outside the S&P 500 index, including smaller cap stocks in the Russell 1000 index.

New capital requirements

The Federal Reserve noted that some 35 banks that will be impacted by the rule have a shortfall of $100 billion and would be required to switch their asset allocation to meet the new $2.5 trillion threshold by the time the rule is phased in by January 2017.  The Fed official quoted in the report did not see any shortage of US Treasury securities developing as a result.

While the proposed rules address liquidity during a credit crisis, they do not tackle what is considered among the most significant concerns: the nearly $700 trillion in over the counter derivatives exposure the banks maintain.  These insurance-like products have “super priority status,” thanks to recent legislation. If the derivatives were to implode, as happened in 2008, it could wipe out the available FDIC insurance fund and the world economy several times over. The Bankruptcy Reforms Act of 2005 grants priority of derivatives over other asset claims. The FDIC fund is currently under $30 billion dollars and could become insolvent if the big bank derivative positions were to collapse.