The Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC—and, together with the FRB and FDIC, Agencies), have each adopted a final rule (the Final Rule1) to impose a quantitative liquidity coverage ratio (LCR) requirement on US banking organizations with total consolidated assets of $250 billion or more, or total consolidated on-balance sheet foreign exposure of $10 billion or more, and their subsidiary depository institutions with $10 billion or more of total consolidated assets (collectively, Covered Companies).
Adopted by the Agencies on September 3, 2014, the Final Rule requires Covered Companies to maintain a sufficient amount of unencumbered high quality liquid assets (HQLA) to meet 100 percent of their projected cash outflows over a stressed 30-day period. A simpler, less stringent LCR applies to depository institution holding companies with $50 billion or more of total consolidated assets that are not Covered Companies (Modified LCR Companies).2
The Final Rule will become effective for Covered Companies on January 1, 2015, and for Modified LCR Companies on January 1, 2016, in each case subject to the transition requirements discussed below.
Notably, the Final Rule will not apply to non-bank financial institutions that have been designated by the Financial Stability Oversight Council as “systemically important” (SIFIs). However, the FRB expects to establish tailored LCR requirements for SIFIs on an individualized or category-wide basis. The Final Rule also does not generally apply to foreign banking organizations (FBOs) or their US operations (unless those US operations are themselves Covered Companies). Again, however, the FRB plans to propose a separate LCR-type requirement for the US operations of “some or all” FBOs with at least $50 billion in combined US assets.3
The Final Rule is substantially the same as that proposed last October (the Proposal4), except for the following material changes:
- Changes to the methodology for capturing maturity mismatches between outflows and inflows;
- Modification of transition periods to provide time to comply with daily reporting requirements;
- Broadening the recognition of certain debt and equity securities as HQLA; and
- Adjustments to the treatment of specific categories of cash inflows and outflows.
Each of these changes is reviewed below.
Changes to the Methodology for Capturing Maturity Mismatches Between Outflowsand Inflows
The Proposed Rule’s use of a “peak net outflow day test,” and in particular the proposed assumption that outflows with no contractual maturities were assumed to occur on the first day of the period, were criticized by the industry as representing a significant departure from the LCR of the Basel Committee on Bank Supervision (BCBS), and as likely to result in significantly overstated liquidity requirements. In response to this criticism, the Final Rule modifies the proposed cumulative peak day approach and imposes a maturity mismatch “add-on.” The add-on is the difference between (x) the largest single-day maturity mismatch amount (determined by calculating the daily difference in cumulative outflows and inflows that have specified maturities within the related 30-day stress period) and (y) the net cumulative outflow amount for those same outflow and inflow categories on the last day of that period. Neither of these amounts can be negative and, despite industry objections, net inflows remain capped at 75 percent of net outflows.
Significantly, however, the Final Rule eliminates the Proposal’s assumption that outflows with no specified maturities occur on the first day of the 30-day stress period.
Modification of Transition Periods to Provide Time to Comply with Daily ReportingRequirements
The phase-in of the minimum LCR requirement remains the same as proposed (and more accelerated than under the BCBS LCR): 80 percent by January 1, 2015; 90 percent by January 1, 2016; and 100 percent starting January 1, 2017. However, Covered Companies will be given additional time to comply with the daily reporting requirements and will be permitted to calculate the LCR only monthly during that transition period.
The requirement for a daily LCR calculation for the largest, most systemically important Covered Companies (with $700 billion of more in total consolidated assets or $10 trillion or more in assets under custody) will begin on July 1, 2015, with other Covered Companies calculating their LCR on a daily basis beginning on July 1, 2016.
In addition, Modified LCR Companies will not be subject to the Final Rule until January 1, 20165 and will only be required to calculate their LCR monthly rather than daily as originally proposed.
Broadening the Recognition of Certain Debt and Equity Securities as HQLA
The Final Rule does not assume that level 2 collateral for secured public sector and corporate trust deposits (collectively, Collateralized Deposits) will be immediately returned as had been originally proposed. This change was in response to comments that had expressed concerns relating to the treatment of Collateralized Deposits and the proposed assumption that level 2 collateral would be immediately returned.
The Final Rule also does not require that an otherwise qualifying corporate debt security be publicly traded in order to qualify as level 2B liquid assets for HQLA. In the Proposal, corporate debt securities had to be publicly traded on a national exchange in order to qualify as HQLA.
Finally, the Final Rule replaces the S&P 500 Index for qualifying equity securities with the Russell 1000 Index. The Final Rule notes that the Russell 1000 Index is based on predetermined criteria, while a committee evaluates and selects component securities for the S&P 500.
Although state and municipal securities remain excluded from HQLA treatment under the Final Rule, the Agencies are considering issuing a separate proposal that would permit certain highly liquid state and municipal securities to qualify as HQLA.
Adjustments to the Treatment of Specific Categories of Cash Inflows and Outflows
Commenters also had argued that certain proposed outflow rates were too high (even though they had been calibrated using substantial supervisory data). In response to specific concerns, the Final Rule makes three adjustments to outflow rates. They include: a maximum outflow rate for a wholesale, non-financial counterparty equal to that for an unsecured funding transaction with such counterparty (since under some circumstances the outflow rate for a secured funding transaction could have had a higher outflow rate than for an unsecured funding transaction with the same counterparty); the Proposal’s 100 percent outflow rate for special purpose entities (SPEs) has been limited with a focus of applying such 100 percent rate primarily to SPEs that rely on market funding (the issuance of securities or commercial paper) with lower outflow rates for other SPEs; and reduced outflow rates for certain wholesale deposits placed by a customer in connection with services provided to the customer by the relevant Covered Company.
Also, under the Final Rule, where a bank is a sponsor of a structured transaction (which would include securitizations) and the issuing entity is not consolidated on the bank's balance sheet under GAAP, an outflow amount is assigned to the transaction that is the greater of (i) 100 percent of the amount of all obligations of the issuing entity that mature within 30 days or less from the relevant calculation date and (ii) the maximum contractual amount of funding the bank may be required to provide the issuing entity within 30 days or less of the calculation date. The same outflow amount would have applied under the Proposal, but would have applied to all sponsored structured transactions, regardless of whether the bank consolidated the issuing entity. The change has the effect of exempting many bank-sponsored securitizations from the provision given that, since the adoption of FAS 167, many, if not most, securitization special purpose entities sponsored by banks are consolidated by those banks under GAAP (Consolidated Bank SPEs). For Consolidated Bank SPEs, the applicable outflow rates will depend on the characterization of the issuing entity as well as the nature of the commitment as liquidity or credit, and will range from 5-100 percent.
The Final Rule also provided relief from the Proposal’s automatic 100 percent outflow rate for commitments to SPEs. In response to industry comment, the Final Rule now permits banks to “look through” an SPE to the type of entity that consolidates such SPE in many transactions with the effect that the 100 percent outflow rate in the Proposal will now be 10 percent, 30 percent or 40 percent. The interrelationship of the various outflow rates for SPEs is complex and we suggest that banks review these provisions thoroughly with their advisers.