As federal regulators consider allowing banks to hold municipal bonds as part of the new liquidity rule, we urge them to understand the potential consequences of failing to act.
The liquidity rule, approved earlier this month by the Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, requires large financial institutions to hold enough liquid assets to fund their operations for 30 days if other sources of funding aren’t available.
The measure is intended to enable banks to fund themselves in the event of an emergency similar to 2008, when a lack of liquidity froze financial markets.
Under the new rule, municipal bonds issued by states and localities will not be considered “high-quality liquid assets,” for this purpose, and therefore wouldn’t count toward satisfying the requirement.
Rule could raise costs for cities, states
Local governments fear the rule would result in banks reducing their muni holdings and increase borrowing costs for states and municipalities, which rely on tax-free bonds to fund infrastructure projects.
The banks also oppose excluding muni bonds.
“History shows that municipal securities remain liquid across various stress scenarios and do not immediately lose their liquidity upon the occurrence of risk,” chief financial officers of 18 cities wrote in a letter to the three regulatory agencies.
Sen. Charles Schumer is among the loudest voices advocating a change.
“Financial experts agree that certain municipal bonds should be considered high quality liquid assets and financial institutions ought to be able to count them that way,” Schumer said.
“The broad exclusion of all municipal bonds from counting as HQLA under the current rules makes no sense on the merits and could have disastrous side effects….”
At a recent Senate Banking Committee hearing, the senator urged the agencies to consider investment-grade municipal bonds as HQLA, an idea regulators are contemplating.
“A number of commenters have expressed concern about the exclusion of municipal securities from HQLA in the final rule,” Martin J. Gruenberg, chairman of the FDIC, said in his prepared testimony at the meeting.
“It is our understanding that banks do not generally hold municipal securities for liquidity purposes, but rather for longer term investment and other objectives.
We will monitor closely the impact of the rule on municipal securities and consider adjustments if necessary.”
Less liquidity
In our view, Gruenberg’s thoughts on why banks hold municipal bonds do not take into account the likely unintended consequences of failing to categorize munis as HQLA.
Historically, large banking institutions have been the pillars of the tax-free bond market. They currently hold about $425 billion in munis, approximately double the amount held in 2008.
If the rule remains intact, these firms may become considerably less active in the market as they opt for other assets – which qualify under the new rule – to enhance their financial statements.
The result would reduce competitive pricing for investors who wish to sell their securities and cause the tax-free bond market to actually become more illiquid, to the detriment of investors as well as issuers.
Given the widespread support behind changing the rule and a simple analysis of its potential consequences, we are hopeful the regulators will reconsider their decision.