Five years ago, the nation’s largest financial institutions faced what amounted to a mass bank run that forced all of them to seek emergency cash and U.S. government bonds from the Federal Reserve to stave off collapse. On Thursday, the Fed proposed a requirement in hopes of preventing the events of 2008 from ever happening again.
The measure requires big financial institutions to have enough cash and easy-to-sell securities to withstand a 30-day run on the bank, which assumes that creditors would pull funding, trading counterparties would demand more collateral, depositors would flee and business borrowers would demand more loans to shore up their own balance sheets.
The introduction of the “liquidity coverage ratio," or LCR, marks the first time U.S. regulators have required banks to have a specific amount of liquid assets in order to withstand a run on the bank or a credit crunch. U.S. financial regulation for years has focused on capital, or the ratio of equity-to-debt that a bank uses to fund its loans and securities.
It follows lessons learned from the 2007-09 crisis, during which big banks’ ability to provide liquidity, or cash on demand, was severely impaired as financial institutions grew distrustful of one another’s strength, even when banks’ capital levels suggested they were healthy institutions.
The result -- reduced lending and a system-wide move to hoard cash and safe securities such as U.S. government debt -- led the Fed to pump trillions of dollars directly into financial companies to ensure markets didn’t collapse. At its peak, on one day in December 2008 the Fed lent financial companies more than $1 trillion.
“This rule would help ensure that the liquidity positions of our banking firms do not weaken as memories of the crisis fade,” said Daniel Tarullo, the Fed’s point person for financial regulation on its Board of Governors.
Global regulators had already agreed to the liquidity rule in 2010 as part of the Basel III banking accords, but weakened it in January after regulators in Europe and banks around the world complained that it would lead to less credit availability and hamper economic growth. Over the past year, U.S. banks including Citigroup, Morgan Stanley, JPMorgan Chase and Wells Fargo have told analysts and investors they hold enough cash and liquid assets to exceed the international version of the rule.
The Fed’s version is tougher, regulators said, underscoring the central bank’s continuing worry that the nation’s largest banks, such as JPMorgan and Goldman Sachs, still pose great risk to the U.S. financial system.
The move, when considered alongside previous measures that also went beyond internationally agreed-upon standards, is likely to further the Fed’s burgeoning reputation as among the world’s strictest financial regulators, a reversal of its pre-crisis reputation as being among the most lax.
New measures to combat flighty funding are in the works, Fed officials have said. Janet Yellen, Fed vice chairman and President Barack Obama’s pick to lead the central bank after Chairman Ben Bernanke steps down in the coming months, on Thursday reiterated her concerns about financial companies’ reliance on short-term funding.
Yellen said she was "pleased" that the banks affected by the proposal "are already well on the way to meeting its requirements." However, she noted, "while this is an important step forward, there is still more work to do."
U.S. banks with more than $250 billion in assets or substantial international operations face the most stringent version of the proposal, which still could be altered before it is finalized. Banks with less than $50 billion in assets don’t fall under it all. Banks with assets between $50 billion and $250 billion face an eased version.
It’s unclear whether U.S. banks that previously claimed they met the international requirement are currently compliant with the proposed U.S. version of the rule. Fed officials estimate that U.S. banks need a total of $2 trillion to meet the requirements, and at present are short by about $200 billion, or 10 percent -- a reflection of banks’ efforts to strengthen their balance sheets and improve their funding positions in the wake of the crisis.
David Emmel, manager of credit, market and liquidity risk policy at the Fed, said a “substantial number” of banks either meet or are close to meeting the requirements.
Much of Wall Street and some Obama administration officials have feared that the proposed rule, with its incentive for banks to hold substantial amounts of U.S. Treasuries, risks creating a situation in which the demand for safe securities outstrips supply, leading to a shortage of so-called safe assets.
For example, the U.S. Treasury has been studying how the proposal may affect the market for U.S. government debt. Some Fed officials have dismissed these concerns, noting there are plenty of safe assets to meet the new regulatory requirements.
Such concerns are likely to be detailed in the coming months. The proposal is open for public comment. The Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, the two other federal bank regulators, also will propose the rule in the coming weeks.
The rule assumes that sources of banks’ funding would evaporate at specified rates in a crisis, as counterparties and customers demand more cash and other safe financial instruments.
Regulators are forcing banks to have enough cash and liquid securities, or “high quality liquid assets,” to counteract those demands and remain strong enough to survive. Banks have to hold on their balance sheets 100 percent of the anticipated amount of cash that regulators believe will be demanded over the 30-day window.
U.S. banks have to meet the requirements by 2017, two years before their international peers. They also face more limits on the kinds of assets they can use to count toward the requirements, and they have to hold enough cash and safe securities to meet the most severe demands that could occur within 30 days. The global version, meanwhile, only requires banks to have enough liquid assets by the 30th day.
U.S. government debt, the benchmark for safety, counts as a safe and liquid security. Debt issued by government-sponsored entities such as home loan giants Fannie Mae and Freddie Mac and mortgage securities guaranteed by those firms are treated as slightly less-liquid assets, a loss for banks that had hoped the Fed would treat Fannie Mae and Freddie Mac securities as equivalent to government debt.
Investment-grade corporate debt and shares issued by publicly traded companies included in the Standard & Poor’s 500 Index also count as part of a bank’s stock of liquid assets. But like Fannie Mae and Freddie Mac securities, banks are limited in how much they can count toward their requirements. The securities also are discounted. For example, for every $1 of Fannie Mae debt a bank holds, only $0.85 counts towards meeting the requirement.
Municipal debt and mortgage-backed securities not guaranteed by the government, along with some other financial instruments, do not count at all in the U.S. version of the rule. Global regulators had agreed to allow some mortgage securities to count as liquid assets.
The U.S. proposal is likely to be met with stiff resistance from financial companies, which have been lobbying regulators to relax the proposal ahead of its formal introduction. For example, the Clearing House, which represents the largest U.S. banks, argued that banks’ ability to borrow from the Federal Home Loan Banks -- government-sponsored entities that lend to banks in order to fuel more mortgage loans -- should count as part of their stock of liquid assets.
As bankers lobby in the coming months to change aspects of the proposal they find troubling, they may find comfort in an April speech delivered by Jeremy Stein, a member of the Fed’s Board of Governors, who suggested that regulators recognize banks’ ability to tap central banks for emergency loans during times of crisis when designing the liquidity rule.
Describing banks’ access to cheap Fed loans as a “backup plan,” Stein said, “One does not want to rely too much on that backup plan, but its presence should nevertheless factor into the design of liquidity regulation.”
William Nelson, deputy director of the Fed’s monetary affairs division, said Thursday that global regulators continue to discuss whether banks’ access to credit from central banks should factor into the liquidity rule.