United States: Federal Regulators Release Liquidity Coverage Ratio Proposed Rule

The Board of Governors of the Federal Reserve System (the "Fed"), the Office of the Comptroller of the Currency (the "OCC") and the Federal Deposit Insurance Corporation (the "FDIC," and together with the Fed and the OCC, the "Bank Regulators") recently approved¹ and published a joint Notice of Proposed Rulemaking (the "NPR") entitled, "Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring." The NPR proposes to implement in the United States the quantitative liquidity coverage ratio standard established by the Basel Committee on Banking Supervision (the "Basel Committee") as part of the Basel III capital and liquidity reforms ("Basel III").

This memorandum summarizes the NPR, identifies key areas where the NPR deviates from the Basel III standards and provides insight into how the proposal could potentially impact those entities subject to the NPR.

International Background

Earlier this year, the Basel Committee issued the full text of its revised liquidity coverage ratio (the "Basel III LCR"), which was first introduced in December 2010 as part of Basel III. The Basel III LCR requires that a bank have an adequate stock of cash and unencumbered, high-quality liquid assets that can be easily converted to cash (collectively, the "Basel III HQLA") to meet such bank's liquidity needs during a 30 day liquidity stress scenario. In a non-stress economic environment, the minimum Basel III LCR requirement is 100%; that is, a bank's stock of Basel III HQLA over such bank's total net cash outflows during a 30-day stress scenario (each as determined in accordance with the Basel III LCR methodology) must equal or exceed 100%. The Basel III LCR, along with the Basel III Net Stable Funding Ratio (the "Basel III NSFR")², are the first attempts by the Basel Committee to establish internationally harmonized quantitative liquidity standards.

The Basel III standards, including the Basel III LCR, are not binding on any bank or nation; it is the task of each individual Basel Committee member nation, including the United States, to implement the Basel III standards through its legislative process. Earlier this year the Bank Regulators issued final rules implementing the Basel III capital reforms, and it was understood that proposed rules to implement the Basel III liquidity reforms would follow.

United States Background

The Bank Regulators note in the NPR that current United States regulations do not impose a quantitative liquidity standard (such as the Basel III LCR) on United States banks; rather, the Bank Regulators have historically monitored liquidity risk "on a case-by-case basis in conjunction with their supervisory processes." Since the financial crisis the Bank Regulators have sought to enhance their oversight of banks' liquidity risk by, e.g., issuing guidance on liquidity risk management best practices and proposing enhanced liquidity standards under Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Section 165 NPR"); the NPR seeks to further enhance the Bank Regulators' oversight of liquidity risk.

The Bank Regulators note that they continue to work with the Basel Committee regarding the ongoing international study of the Basel III LCR, and that they would consider amending the NPR if the Basel Committee proposes modifications to the Basel III LCR in the future.

Overview of the NPR

Comment Deadline

The Bank Regulators have asked that comments on the NPR be submitted by January 31, 2014. While the Bank Regulators are inviting comment on all aspects of the NPR, they have also included more than 70 specific questions throughout the NPR. When appropriate, the Bank Regulators have asked that commenters include with their comment letters detailed qualitative or quantitative analysis, as well as "any relevant data and impact analysis to support their positions."

Scope of Application

The NPR proposes to impose some variation of the Basel III LCR on the following "Covered Companies":

1. all internationally active banking organizations, i.e., banking organizations with $250 billion or more in total assets or $10 billion or more in on-balance sheet foreign exposure ("Internationally Active BHCs");
2. consolidated subsidiary depository institutions of Internationally Active BHCs with $10 billion or more in total consolidated assets;
3. certain non-bank financial companies designated for Fed supervision by the Financial Stability Oversight Council ("Covered Nonbank Companies") that do not have significant insurance operations;
4. consolidated subsidiary depository institutions of Covered Nonbank Companies with $10 billion or more in total consolidated assets (together with those entities identified in clauses 1., 2. and 3. above, "Unmodified LCR Companies"); and
5. bank holding companies ("BHCs") and savings and loan holding companies ("SLHCs") with $50 billion or more in total consolidated assets that do not have significant insurance or commercial operations ("Modified LCR Companies").

In addition, the Bank Regulators note that they are reserving the authority to apply the liquidity coverage ratio ("LCR") described in the NPR to "a company not meeting the asset thresholds...if it is determined that the application of the proposed liquidity coverage ratio would be appropriate in light of a company's asset size, level of complexity, risk profile, scope of operations, affiliation with foreign or domestic covered companies, or risk to the financial system."

Transition Period

The Bank Regulators have proposed a more aggressive transition period for implementation of the LCR than the transition period proposed by the Basel Committee for implementation of the Basel III LCR.

The NPR would require Covered Companies to have a minimum LCR of:

1. 80% by January 1, 2015;
2. 90% by January 1, 2016; and
3. 100% by January 1, 2017.

The transition period proposed by the Basel Committee for the Basel III LCR is as follows:

1. 60% by January 1, 2015;
2. 70% by January 1, 2016;
3. 80% by January 1, 2017;
4. 90% by January 1, 2018; and
5. 100% by January 1, 2019.

Interestingly, the Bank Regulators note that their decision to propose a more aggressive transition period for implementation of the LCR in the United States than that proposed by the Basel Committee is due to "the strong liquidity positions many U.S. banking organizations and other companies that would be subject to the proposal have achieved since the recent financial crisis."

LCR Proposal

General. Like the Basel III LCR, the LCR standard proposed in the NPR would implement a minimum quantitative liquidity requirement on Covered Companies, "with some modifications [from the Basel III LCR] to reflect characteristics and risks of specific aspects of the U.S. market and U.S. regulatory framework." The LCR calculation would be different for Unmodified LCR Companies and Modified LCR Companies, as described below.

The LCR would require Unmodified LCR Companies, during periods of non-stress, to maintain an amount of high quality liquid assets ("HQLA") that is not less than 100% of its total net cash outflows over a prospective 30 calendar day period, each as calculated in accordance with the NPR and subject to the transition schedule described above; Modified LCR Companies would use a 21 calendar day period for their LCR calculations.

In a departure from how the Basel III LCR is calculated, the total net cash outflow amount for purposes of the LCR calculation of Unmodified LCR Companies would be the dollar amount on the day within a 30 day stress period that has the highest amount of net cumulative cash outflows (under the Basel III LCR the denominator is total net cash outflows as of the end of the 30 day stress period). The Bank Regulators state that they departed from the Basel III LCR in this regard "because [the change] takes into account potential maturity mismatches between a Covered Company's outflows and inflows, that is, the risk that a Covered Company could have a substantial amount of contractual inflows late in a 30 day stress period while also having substantial outflows early in the same period." However, the Bank Regulators did not apply this rationale to the LCR calculation of Modified LCR Companies, which utilizes total net cash outflows as of the end of the 21-day stress period. The Bank Regulators note that they believe this approach is appropriate because Modified LCR Companies "would likely be less dependent on cash inflows" to meet the LCR requirements, "thereby reducing [their] likelihood of having a significant maturity mismatch within a 21 calendar day stress period."

The Bank Regulators state that "under certain circumstances, it may be necessary for a Covered Company's LCR to briefly fall below 100% to fund anticipated liquidity needs," and note that the NPR "would establish a framework for flexible supervisory response when a Covered Company's LCR falls below 100%."

The Bank Regulators are reserving the authority to require a Covered Company to hold a greater amount of HQLA than the minimum required by the NPR, "or to take any other measure to improve the Covered Company's liquidity risk profile, if the relevant agency determines that the Covered Company's liquidity requirements as calculated under the NPR are not commensurate with its liquidity risks."

Modified LCR Companies. As noted above, Modified LCR Companies are required to calculate their LCRs in a different manner than Unmodified LCR Companies. A Modified LCR Company:

1. must use a 21 calendar day period for its LCR calculations (as opposed to a 30 calendar day period for Unmodified LCR Companies);
2. does not use the largest daily calculation of net cumulative cash outflows within the 21 calendar day stress period as the denominator of the LCR (whereas Unmodified LCR Companies must use the dollar amount on the day within a 30 day stress period that has the highest amount of net cumulative cash outflows as the denominator of the LCR); and
3. only counts 70% of outflows and inflows for instruments/transactions that have no contractual maturity date during the 21 calendar day stress period (it is 100% for Unmodified LCR Companies).

A Modified LCR Company is also not required to have any large depository institution subsidiaries calculate a separate LCR (whereas large depository institution subsidiaries of Unmodified LCR Companies must calculate and satisfy a separate LCR).

The modified LCR applicable to Modified LCR Companies should generally result in such entities having to hold less HQLA than if they were required to calculate their LCRs in the same manner as Unmodified LCR Companies.

LCR Reporting. Each Covered Company must calculate its LCR as of the same time on each business day and must, by written notice to the relevant Bank Regulator prior to the effective date of the rule, select the time of day when it will calculate its LCR (this time of day cannot be changed without written approval from the relevant Bank Regulator).

A Covered Company must notify the relevant Bank Regulator on any business day when its LCR fails to meet the minimum requirement, and if such failure continues for three consecutive business days the Covered Company must "promptly" provide to the relevant Bank Regulator a remediation plan ("Remediation Plan") for achieving compliance with the minimum requirement. Such a Remediation Plan must include:

1. an assessment of the Covered Company's liquidity position;
2. the actions the Covered Company has taken and will take to achieve full compliance with the LCR, including a plan for adjusting the Covered Company's "risk profile, risk management, and funding sources" and a plan for "remediating any operational or management issues that contributed to noncompliance";
3. an estimated timeframe for achieving full compliance with the LCR; and
4. a "commitment" to report to the relevant Bank Regulator "no less than weekly on progress to achieve compliance in accordance with the plan until full compliance is achieved."

Absent failure to comply with the minimum LCR requirement, the current NPR does not contain any reporting requirements; however, the Bank Regulators "anticipate that they will separately seek comment upon proposed regulatory reporting requirements and instructions pertaining to a Covered Company's disclosure of the proposed rule's LCR in a subsequent notice."

HQLA. The numerator of the LCR is the fair value (under U.S. GAAP) of a Covered Company's stock of HQLA, as determined and calculated pursuant to the methodology set forth in the NPR.
Under the NPR, and similar to how Basel III HQLA are categorized, HQLA are divided into three categories:

1. Level 1, which are "the highest quality and most liquid assets" and can be included in a Covered Company's HQLA without limitation and without any haircut;
2. Level 2A, which are subject to a 15% haircut and, when combined with Level 2B assets, cannot exceed 40% of the total stock of a Covered Company's HQLA; and
3. Level 2B, which are subject to a 50% haircut and cannot exceed 15% of the total stock of a Covered Company's HQLA.

The haircuts and percentage limitations applicable to Level 2A and Level 2B HQLA under the NPR are the same as those contained in the Basel III LCR. However, the NPR requires that Covered Companies calculate the Level 2A/Level 2B HQLA 40%/15% caps as of both the first day and last day of an LCR calculation period, with the last day calculation taking into account the unwind of any secured funding transactions, secured lending transactions, asset swaps and collateralized derivatives transactions that mature within the LCR calculation period (i.e., those that mature within the next 30 calendar days for Unmodified LCR Companies and the next 21 calendar days for Modified LCR Companies); the calculation that results in the greatest amount of HQLA that exceed the 40%/15% caps (and are therefore deducted from the stock of HQLA) is used. The Basel III LCR requires the cap calculation to be made only as of the last day of the Basel III LCR calculation period, after giving effect to the unwind of the maturing securities financing transactions during such period.

HQLA must also meet the following requirements:

1. be "liquid and readily-marketable," meaning the security is traded in an active secondary market with (a) more than two committed market makers, (b) a large number of non-market maker participants on both the buying and selling sides of transactions, (c) timely and observable market prices and (d) a high trading volume (this requirement does not apply to securities issued by, or unconditionally guaranteed by, the U.S. Treasury, and certain U.S. reserve bank balances and foreign withdrawable reserves);
2. specified operational requirements, such as, for example, (a) a Covered Company periodically monetizing a sample of HQLA and (b) the HQLA being under the control of the management function at the Covered Company that is charged with managing liquidity risk;
3. be "unencumbered," meaning the assets are free of legal, regulatory, contractual or other restrictions on the ability of the Covered Company to monetize the asset, and the asset is not pledged to provide credit enhancement to any transaction (except that assets may be pledged to a central bank or a U.S. government-sponsored enterprise ("GSE")³ if potential credit secured by the assets is not currently extended to the Covered Company or its consolidated subsidiaries);
4. not be issued by certain financial sector entities, including regulated financial companies (such as BHCs, SLHCs, Covered Nonbank Companies, depository institutions, insurance companies, etc.), registered investment companies (including mutual funds and money market funds), certain non-regulated funds, pension funds, registered investment advisers, or a consolidated subsidiary of any of the foregoing; and
5. certain other generally applicable criteria specified in the NPR.

Level 1 HQLA

Level 1 HQLA include the following:

1. most Federal Reserve Bank deposits, other than certain term deposits and reserve balance requirements;
2. foreign withdrawable reserves, i.e., reserves held in a foreign central bank that are not subject to restrictions on use;
3. securities issued by, or unconditionally guaranteed by, the U.S. Treasury or a U.S. government agency whose obligations are fully and explicitly guaranteed by the U.S. government;
4. securities issued by, or unconditionally guaranteed by, a sovereign entity, the BIS, the IMF, the ECB or a multilateral development bank, in each case subject to certain conditions, including that the security receive a 0 percent risk weight under the new capital rules; and
5. securities issued by, or unconditionally guaranteed by, sovereign entities that do not receive a 0 percent risk weight under the new capital rules but meet certain other requirements, including being held by the Covered Company to meet its net cash outflows in the jurisdiction of the issuer.

While not in the enumerated list of Level 1 HQLA in the NPR, cash presumably is also included in Level 1 HQLA.

The list of assets that qualify as Level 1 HQLA under the NPR is extremely similar to the list of assets that qualify as Level 1 Basel III HQLA under the Basel III LCR.

Level 2A HQLA

Level 2A HQLA include the following:

1. securities issued by, or guaranteed by, a U.S. GSE that are investment grade (as determined under the new capital rules) as of the LCR calculation date, and are senior to preferred stock; and
2. securities issued by, or guaranteed by, a sovereign entity or multilateral development bank that are not Level 1 HQLA, receive no higher than a 20% risk weight under the new capital rules, and meet certain other specified liquidity requirements.

The list of Level 2A HQLA in the NPR significantly departs from the list of Level 2A Basel III HQLA in terms of excluding corporate debt securities, U.S. state and municipal securities and covered bonds, in each case rated at least AA-, which are all included in the list of assets that qualify as Level 2A Basel III HQLA (assuming they meet certain other requirements). The Bank Regulators note that covered bonds and state and municipal securities do not meet the liquid and readily-marketable requirement "at this time."

Level 2B HQLA

Level 2B HQLA include the following:

1. publicly traded corporate debt securities that are investment grade (as determined under the new capital rules) as of the LCR calculation date and meet certain other specified liquidity requirements; and
2. publicly traded common equity shares that are included in the S&P 500 (or certain other stock indices) and that meet certain other specified liquidity and operational requirements.

The Level 2B Basel III HQLA also includes certain residential mortgage backed securities, which are excluded from the list of Level 2B HQLA in the NPR.

Total Net Cash Outflow. The denominator of the LCR is a Covered Company's total net cash outflow amount as determined and calculated pursuant to the methodology set forth in the NPR. The total net cash outflow amount is arrived at by:

1. multiplying each specified category of outflows by a specified outflow rate, and then adding the products together to arrive at a cumulative stressed outflow amount;
2. multiplying each specified category of inflows by a specified inflow rate, and then adding the products together to arrive at a cumulative stressed inflow amount; and
3. subtracting from the cumulative stressed outflow amount the lesser of (a) the cumulative stressed inflow amount or (b) 75% of the cumulative stressed outflow amount (consistent with the Basel III LCR, the cumulative stressed inflow amount is capped at 75% of the cumulative stressed outflow amount).

As previously noted, in a departure from the Basel III LCR methodology, Unmodified LCR Companies would be required to (i) determine a net cumulative cash outflow amount for each day during the 30 calendar day LCR calculation period and (ii) utilize in the denominator of its LCR calculation as the total net cash outflow amount the dollar amount on the day during such calculation period that has the highest amount of net cumulative cash outflows. Modified LCR Companies would use the net cumulative cash outflow amount on the last day of the 21 calendar day LCR calculation period applicable to such companies as the total net cash outflow amount, even if there was a day during the 21 calendar day LCR calculation period that had higher net cumulative cash outflows (using the net cumulative cash outflow amount on the last day of the LCR calculation period is consistent with the Basel III LCR methodology).

Determining the Maturity Of Instruments and Transactions

The NPR requires Covered Companies to identify the maturity or transaction date that is "the most conservative for an instrument or transaction in calculating inflows and outflows (that is, the earliest possible date for outflows and the latest possible date for inflows)." For example, when determining outflows a Covered Company must assume that any option to accelerate maturity would be exercised by a counterparty; however, when determining inflows a Covered Company must assume that any option to extend maturity would be exercised by a counterparty. In addition, (i) items with no contractual maturity date can be additive to outflows but are explicitly excluded from inflows and (ii) intragroup transactions are generally excluded from both outflows and inflows.

Cash Outflow Categories and Outflow Rates

The table below sets forth the different outflow categories and corresponding outflow rates that would be used by an Unmodified LCR Company when calculating its total net cash outflow amount. For a Modified LCR Company, the outflow rate would be 70% of the outflow rate presented in the table below for instruments/transactions that do not have a contractual maturity date during the 21 calendar day LCR calculation period applicable to such company. For all Covered Companies, the default outflow rate for any other contractual payment due within the applicable LCR calculation period is 100%.

The NPR contains detailed definitions and explanations relating to each outflow category.

Cash Inflow Categories and Inflow Rates

The table below sets forth the different inflow categories and corresponding inflow rates that would be used by an Unmodified LCR Company when calculating its total net cash outflow amount. For a Modified LCR Company, the inflow rate would be 70% of the inflow rate presented in the table below for instruments/transactions that do not have a contractual maturity date during the 21 calendar day LCR calculation period applicable to such company. For all Covered Companies, the default inflow amount for items not specifically included in inflows is 0.

The NPR contains detailed definitions and explanations relating to each inflow category.

The NPR identifies six categories of items that are explicitly excluded from cash inflows for all Covered Companies:

1. amounts held by a Covered Company in operational deposits at regulated financial companies;
2. amounts expected to be received by the Covered Company from derivative transactions relating to forward sales of mortgage loans and any derivatives that are mortgage commitments;
3. amounts arising from any credit or liquidity facility extended to the Covered Company;
4. amounts of any asset included in the Covered Company's stock of HQLA (including all HQLA that mature within the relevant LCR calculation period), and any amount payable to the Covered Company with respect to such assets;
5. any outstanding exposure to a counterparty that is nonperforming (defined to mean payments are more than 90 calendar days past due or are on nonaccrual as of the calculation date, and those that the Covered Company expects will become more than 90 days past due during the LCR calculation period); and
6. items that have no contractual maturity date during the LCR calculation period.

Additional Observations

Interaction With Other Recently Proposed Liquidity Rules

As noted in the NPR, the Section 165 NPR (published in the Federal Register on January 5, 2012) relating to enhanced prudential standards for certain large United States banking organizations contains enhanced liquidity standards, including a liquidity buffer requirement loosely modeled on the Basel III LCR. The preamble to the NPR implies that the proposed LCR requirement is meant to complement, not replace, such liquidity buffer requirement.

However, the Section 165 NPR liquidity buffer does not, e.g., differentiate between Modified and Unmodified LCR Companies, does not separate HQLA into different levels, etc. Therefore, it is possible that certain Covered Companies will need to run two separate "liquidity buffer" tests, with each utilizing a very different methodology. Needless to say, this would be extremely confusing for all involved. Given that the Section 165 NPR has not yet been finalized, and the current NPR is still in its comment period, there is still an opportunity for the Bank Regulators to harmonize these standards in an effort to minimize the compliance burden on Covered Companies.

U.S. State and Municipality Securities Not HQLA

The NPR excludes (for the time being) all state and municipality securities from HQLA, on the basis that, in the opinion of the Bank Regulators, such securities do not satisfy the "liquid and readily-marketable" requirement. This is a significant departure from the Basel III LCR methodology, and the rationale for the departure is potentially one that could be disproven (at least for some issuers in this universe) by commenters providing past historical trading data.

Mutual Fund and Money Market Fund Shares Not HQLA

While certain publicly traded debt and equity securities of certain types of operating issuers can qualify as a HQLA, securities issued by "investment companies" are excluded from HQLA, without any exceptions. At the very least, a compelling argument could be made that shares held in open-end mutual funds and money market funds that invest exclusively in securities that, if held directly by a Covered Company, would qualify as HQLA should themselves qualify as HQLA.

Compliance Burden

The complexity of the LCR calculation, and the massive amount of data and legal documentation required to be analyzed in order to properly calculate the LCR, cannot be overstated. It is evident that Covered Companies will need to devote significant amounts of personnel, time and other resources to LCR compliance. The fact that the NPR requires a Covered Company to calculate its LCR on a daily basis will only serve to increase the resources a Covered Company must allocate to LCR compliance. Also, as previously noted, the Banking Regulators are not done with rulemaking in this area; at least three additional forthcoming liquidity rulemakings are mentioned in the NPR (i.e., a proposal to implement the Basel III NSFR, a proposal dealing with LCR reporting and final rules relating to the Section 165 NPR).

In addition, for those Covered Companies that may have already developed systems, processes and procedures to monitor liquidity risk based on the Basel III LCR methodology, the significant departures from the Basel III LCR methodology proposed in the NPR could require such companies to have to redevelop such systems, processes and procedures.

Conclusion

The methodology set forth in the NPR for calculating the LCR is extremely complicated, and while the NPR answers some questions that industry participants had regarding the approach the Bank Regulators would take in implementing the Basel III LCR in the United States, like any initial rule proposal it raises a host of others. For this and other reasons, and similar to the response received by other recently proposed rules regarding capital and liquidity that have been published by the Bank Regulators for comment, the NPR is expected to generate a significant amount of feedback from the banking industry.

Footnote

1 The Fed approved the NPR on October 24, 2013; the OCC and FDIC approved the NPR on October 30, 2013.

2 Whereas the Basel III LCR is a short-term quantitative liquidity measurement, the Basel III NSFR seeks to quantitatively measure liquidity resilience over a longer period (i.e., one year). The Basel III NSFR is currently in an international observation period, and the Bank Regulators note in the NPR that they "anticipate that they would issue a proposed rulemaking implementing the NSFR in advance of its scheduled global implementation in 2018." Thus, the current NPR seeks to implement only the Basel III LCR.

3 Defined to mean "an entity established or chartered by the Federal government to serve public purposes specified by the United States Congress, but whose debt obligations are not explicitly guaranteed by the full faith and credit of the United States government." Examples would include the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, the Farm Credit System and the Federal Home Loan Banks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.