Beefed Up Basel: Fed Proposes New Liquidity Regulations

Federal Reserve

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The Federal Reserve Board (Fed) proposed a new rule October 24 to bolster liquidity held by financial institutions. The proposal implements minimum liquidity requirements certain banks, and non-bank fiscal entities that have been identified by the Financial Stability Oversight Council, must meet.

Explaining the potential regulation, Fed Chairman Ben S. Bernanke said, “The proposed rule would, for the first time in the United States, put in place a quantitative liquidity requirement that would foster a more resilient and safer financial system in conjunction with other reforms.” Liquid assets are those easily bought and sold in trades. Liquidity refers to the degree at which an asset or security can be traded. After the financial crisis, world banking leaders met as part of the Basel Committee on Banking Supervision, adopting a Liquidity Coverage Ratio (LCR) as a minimum standard to be met by international banks.

The goal of a minimum LCR helps the overall goals of Basel III by forcing banks to hold enough liquid assets so they do not need a central bank to step in and bail the bank out of a financial crisis. The Basel Committee on Banking Supervision adopted international standards regarding LCR in February. The international standards begin in 2016 with banks required to meet a minimum requirement of 60 percent. This increases by 10 percent in each subsequent year until 100 percent implementation is established across the board in 2019.

The Fed’s proposal starts the process for the U.S. in 2015, when banks need to meet 80 percent of the requirements. Increases of 10 percent in the following years brings full compliance by 2017. It requires that banks and identified institutions have enough capital readily available “to survive an acute stress scenario that lasts 30 days.” Those thirty days can then be used by the bank or instution to draft a plan to remedy the situation. It applies to:

International banks, generally those with consolidated assets of $250 billion or more, or banks with over $10 billion on-balance sheet foreign exposure. Banks falling into this category include JPMorgan Chase & Co. (NYSE: JPM) as well as The Goldman Sachs Group (NYSE: GS).

In the past year, JPMorgan has indicated preparedness for the Basel III requirements to be put in place. In JPMorgan’s second-quarter press release, President and CEO Jamie Dimon said, “This quarter, we exceeded the proposed Basel III Liquidity Coverage Ratio requirement — as of the end of the second quarter, our estimated ratio was 118 percent.”

Non-bank financial institutions, such as American International Group, Inc. (NYSE: AIG), General Electric Capital Corporation, Inc. (NYSE: GEK), and Prudential Financial, Inc. (NYSE: PRU). The reason behind including companies is given by the U.S. Treasury.

In the Treasury’s explanation for AIG, it wants to prevent a situation like what fostered before the financial crisis. AIG branched out, diversifying its services beyond its staple of income, insurance. In 2008, it required government assistance to avoid a greater economic crisis. By forcing companies that can jeopardize the economy in a like manner a bank can, the government is attempting to ensure that any financial institution, bank or not, cannot fall under the “too big to fail” mentality.

A modified version of the LCR plan will apply to banks and lenders who are not internationally active, but have over $50 billion in total assets. Banks with less than $50 billion in assets do not have to comply with the standards.

Fed Governor Daniel K. Tarullo also used the announcement to explain the necessity of the proposal. A financial crisis, he explained, generally begins with a “liquidity squeeze,” making it, “essential that we adopt liquidity regulations to complement the stronger capital requirements, stress testing, and other enhancements to the regulatory system we have been putting in place over the past several years.”

The proposal by the Fed also assigned a 20 percent risk weight to government sponsored enterprises (or GSEs), such as Fannie Mae and Freddie Mac. Again, the government is attempting to reduce exposure to risk. If GSEs had no risk attached, and were classed as the “Level 1″ in the High Quality Liquid Asset (or HQLA) scheme, institutions could hold them without limit, putting the government on the hook again to bail out troubled assets.

Instead, they are in “Level 2″ of HQLA. Level 2 assets are only allowed to comprise 40 percent of an institution’s LCR when combined with “Level 2B” liquid assets. Those assets include publicly traded debts and securities. Or, as Tarullo phrased it, “The rule was designed to prevent the Fed, government and economy from being fooled twice, even time distances the country from the crisis.”

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