On April 1, 2016, the Federal Reserve adopted a final amendment (“Final Amendment”) to its version of the liquidity coverage ratio (the “LCR”) rules to treat certain U.S. municipal securities as high-quality liquid assets (“HQLA”).1 The Final Amendment was adopted largely as proposed (“Proposed Amendment”),2 subject to two important modifications insofar as the Final Amendment: (i) eliminates the proposed limitation on the inclusion of municipal securities in amounts greater than 25 percent of the total outstanding securities with the same CUSIP number; and (ii) permits the inclusion of municipal bonds that are insured or guaranteed by a bond insurer so long as, on a stand-alone basis and absent the insurance or guarantee, the security would otherwise meet the requirements of the Final Amendment (e.g., as described below, investment grade, liquid and readily marketable, etc.). The effective date of the amendment is July 1, 2016. Although the LCR rule itself was originally adopted as an interagency rulemaking with substantively identical rules among the Federal Reserve, the FDIC, and the OCC, the OCC and the FDIC have not proposed any revisions to their respective versions of the LCR to treat municipal securities as HQLA. Therefore, at least for the moment, U.S. banking organizations (for example, bank holding companies and certain state member banks) subject to the Federal Reserve’s version of the LCR rules3 would be able to include these municipal securities in their HQLA calculations, while entities subject only to the OCC’s and the FDIC’s LCR rules would not be permitted to do so.
Consistent with the Proposed Amendment, the Final Amendment permits U.S. banking organizations subject to the Federal Reserve’s version of the LCR rules to include as level 2B liquid assets municipal securities issued or unconditionally guaranteed by any state, local authority, or other governmental subdivision below the U.S. sovereign entity level (referred to in the Final Amendment as “public sector entities” or “PSEs”) that meet the following requirements:
- General Obligations of the PSE. Only securities or other obligations that are backed by the full faith and credit of the issuing PSE (typically referred to as “general obligation” bonds) can qualify as a level 2B liquid asset. Revenue bonds, which are repaid from a specified public revenue source such as a utility or toll system rather than general tax funds, would not qualify under the Final Amendment. In rejecting commenters requests for including revenue bonds, the Federal Reserve notes that, due to their reliance on specific and dedicated revenue streams, the credit quality of revenue bonds can deteriorate more rapidly than general obligation bonds during a period of economic stress, but states that it “will continue to monitor the liquidity characteristics of revenue bonds and consider whether certain revenue bonds should be included as HQLA.”4
- Investment Grade. Consistent with the requirements applied to corporate debt securities that are included as level 2B liquid assets, the Final Amendment includes only municipal securities that are “investment grade” as defined under the LCR rules.
- Issued or Guaranteed by a PSE with a Proven Record as a Reliable Liquidity Source.
Consistent with the requirements applied to corporate debt securities that are included as level 2B liquid assets, the Final Amendment requires that the issuer of the municipal securities be an entity whose obligations have a proven record as a reliable source of liquidity in repurchase or sale markets during a period of significant stress. Banking organizations must demonstrate this record of liquid reliability by showing that the market price of the municipal securities or equivalent securities of the issuer declined by no more than 20 percent during a 30-calendar-day period of significant stress, or that the market haircut demanded by counterparties to secured lending and secured funding transactions that were collateralized by such debt securities or equivalent securities of the issuer increased by no more than 20 percentage points during a 30-calendar-day period of significant stress.
- Not an Obligation of a Financial Sector Entity or Its Consolidated Subsidiary. Consistent with the requirements applied to corporate debt securities that are included as level 2B liquid assets, the Final Amendment excludes municipal securities that are obligations of a financial sector entity or a consolidated subsidiary of a financial sector entity.5 In response to comments, the Final Amendment, unlike the Proposed Amendment, does not automatically disqualify as HQLA municipal securities that are insured or guaranteed by a financial sector entity. Instead, the insured or guaranteed security may qualify as HQLA so long as the security would, on a stand-alone basis and absent the insurance or guarantee, otherwise meet the requirements of the Final Amendment.6
- Liquid and Readily Marketable. Consistent with the requirements applied to all level 2 liquid assets, the municipal bonds must be liquid and readily marketable as defined in the LCR rule.7
To address liquidity risks presented by the structure of the U.S. municipal securities market, the Final Amendment adopts two quantitative limitations on the municipal securities that are eligible for inclusion as level 2B liquid assets.
- Single-Issuer Limitation. First, the amount of eligible municipal securities from a single issuer that a covered company can include as HQLA is limited to two times the average daily trading volume of all general obligation municipal securities of that issuer during the previous four quarters. Despite concern from commenters, the Federal Reserve notes that this limitation is designed to reflect the capacity of increased sales “that could be absorbed by the market during periods of significant stress.”8
- Limitation on Amount that Could Be Included in HQLA Amount. Second, the total amount of municipal securities a covered company can include as HQLA is limited to no more than five percent of the institution’s total HQLA amount to “act as a backstop to address the overall liquidity risk presented by the structure of the U.S. municipal securities market, including the large diversity of issuers and sizes of issuances.”9 This limitation is in addition to the 40 percent limitation on the aggregate amount of level 2A and level 2B liquid assets and the 15 percent limitation on level 2B liquid assets that can be included in the institution’s HQLA amount.
In response to comments, the Final Amendment does not retain from the Proposed Amendment a proposed limitation of municipal securities based on the total amount outstanding of U.S. general obligation municipal securities with the same CUSIP number.