Daily News: October 25, 2013

Fitch: Stricter Bank Liquidity Rules to Affect Profitability

According to Fitch Ratings, the proposed U.S. rule covering minimum liquidity requirements for large banks would enforce a tougher standard than the Basel III international framework outlined in January. Fitch said it sees the proposed U.S. rule as generally positive for bank credit ratings. However, the push for additional liquidity will negatively affect bank profitability if the proposal is implemented.

The proposal, issued recently by the Fed, OCC and FDIC, seeks to implement the liquidity coverage ratio (LCR), which has been developed together with global bank regulators. It will require large banks with more than $250 billion of total assets to hold high-quality liquid assets (HQLA) at sufficient levels to guard against a 30-day period of strained liquidity. Further, banks with more than $50 billion of total assets (but less than $250 billion) will have to hold enough HQLA to withstand a 21-day period of liquidity stress. Smaller banks (less than $50 billion of assets) will get a reprieve from the LCR, Fitch said.

To achieve compliance with the proposed LCR, Fitch said it believes banks would likely need to de-risk their investment portfolios and move towards very liquid lower-yielding government and agency securities. The U.S. standard goes further than the Basel III framework in excluding certain assets from the pool of HQLA. Among these are private label mortgage-backed securities, covered bonds and municipal securities. Fitch estimated that roughly 25% of bank investment portfolios could be excluded from the definition of HQLA based on second-quarter regulatory data.

Alternatively, banks could target LCR compliance by attacking the denominator in the equation. Banks could procure longer, term-funding structures to help achieve compliance by reducing deposit outflow risk. Nevertheless, Fitch said it views either de-risking investment portfolios or longer, term-funding structures as a drag on profitability for most banks. Under the proposal, level 1 securities receive no haircut, and are generally limited to cash, central bank deposits, U.S. Treasury obligations and U.S agency securities fully and explicitly guaranteed by the full faith and credit of the U.S. government, such as Ginnie Mae securities. Other government-sponsored entity (GSE) securities, such as Fannie Mae and Freddie Mac securities, will qualify as level 2A securities, with a 15% haircut. Level 2B securities are given a 50% haircut and are generally limited to investment-grade corporate debt and common stock included in the S&P 500.

The U.S. proposal takes a stricter approach with respect to the LCR implementation timeline. U.S regulators look to expedite the implementation of the rule by requiring banks to achieve 80% compliance with the LCR by 2015, with increases of 10% for the following two years and full implementation by 2017. The international standard only requires 60% compliance in 2015, followed by a 10% increase for the following four years (full implementation in 2019). Fitch said the proposal also takes a tougher stance on intra-period liquidity requirements. The U.S. proposal requires that the largest banks (more than $250 billion) to hold HQLA against their largest net cumulative cash outflow day within a 30-day liquidity stress period, rather than the net cumulative cash outflow as of the end of the period. This represents the regulator’s view that cash outflows could occur significantly before cash inflows within a 30-day liquidity stress period.

Fed staff noted that HQLA levels in the aggregate currently are approximately $200 billion below the targeted level for LCR compliance. However, we believe the two-year window for compliance will provide adequate time for banks to boost liquid assets where needed.