How the Proposed Liquidity Rule for Large Banks Could Trickle Down  to Community Banks

By Leonard J. DeRoma

The proposed liquidity coverage ratio risk measurements do not apply to community banks.  Yet a careful reading of the proposed rulemaking suggests that there are unintended consequences that may hit the community bank market anyway.

The public comment period for Regulation WW,  “Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards and Monitoring,” ended on January 31 with 108 comment letters.  The rule has been modeled on the Basel III Liquidity Coverage Ratio.

As we have discussed with our clients, community banks are not subject to Basel III LCR or the Dodd-Frank derivatives regulations. However, most regulations flow downhill at some point. The LCR application for community banks in a reduced format, or through industry best practices, is almost inevitable. 

In particular, the proposed rule recommends that large U.S. banks should not include municipal bonds munis in the effective portion of the High Quality Liquid Asset (HQLA) computation. That will put a lot of pressure on the banks to find comparative yielding assets that qualify for HQLA treatment. It will also affect the municipal bond market.

A 2012 165-page SEC report on munis noted that there were approximately $3.7 trillion municipal bonds outstanding. Issuance runs in the $400 billion to $600 billion a year range. Commercial banks hold about 8% or approximately $300 billion of munis. Many community banks feel morally obligated to participate in offerings, (as owners, selling group members or in the case of larger banks, underwriters) of local governmental entities in their respective geographic footprints. (It’s good business and it’s what a community bank is supposed to do—help support the community).

The SEC report further points out that the default rate of munis rated Baa or higher was actually lower than corporate bonds rated Aa or higher, which only fuels banker objections. There is also a similar rule change for corporates, although the impact is not as great for community banks.

If the rules are adopted as is, and if regulatory recommendations/best practices continue moving in their current direction, we may see a glacial shift in the ownership structure of the municipal bond market. Banks with longer-dated munis may need to either sell prior to maturity, with potential losses, or increase the size of the asset books by adding HQLA qualifying securities into their portfolio from a now smaller pool of “less risky” securities.

In a future article, we will address the role of the investment portfolio, the strategic implications of the liquidity coverage rule and some tactical solutions.