US regulators approve new-look liquidity rule despite opposition

US financial regulators have approved measures requiring major banks to prove their funding can endure one year of stress, amid objections from minority members of the Federal Reserve and FDIC boards that the revamped rule “defeats the purpose” of the original proposal.

The Federal Deposit Insurance Corporation (FDIC) adopted the net stable funding ratio (NSFR) rule on 20 October after a 3-1 vote of its board. The Office of the Comptroller of the Currency (OCC) and the Federal Reserve Board also finalised the rule.

The new NSFR requires large banks to maintain a minimum level of stable funding over a one-year period, and is relative to each institution’s assets, derivatives, and commitments. It will come into force in June 2021.

The agencies originally proposed the rule in 2016 to bring their rules in line with Basel III standards, and it is designed to complement the liquidity coverage ratio, a measure of cash flow over a 30-day stress period.

Under the NSFR rules, banks are obliged to have enough available stable funding (ASF) to meet their required stable funding (RSF).

In the original notice of proposed rulemaking (NPR) they issued in 2016, the agencies assigned US Treasury securities a 5% RSF weighting, while it gave reverse repurchase (repo) agreements, which are short-term loans secured by liquid collateral, a 10% weighting. Both percentages were consistent with the Basel III standards for NSFR.

However, the new final rule drops the RSF weighting for both instruments to 0%, meaning banks can now meet requirements without securing stable funding for these two assets.

It also reduces the number of banks that are obliged to meet the NSFR requirement. Those with at least US$700 billion of assets must still comply with the full requirement, but banks holding between US$100 and US$250 billion of assets are not required to.

FDIC chairwoman Jelena McWilliams said the final rule is consistent with what was proposed in 2016. She called the changes “improvements to the calibration.”

But FDIC board member and former chairman Martin Gruenberg expressed his disapproval of the final rule, and dissented in the final vote.

Gruenberg said a small RSF requirement would “insulate” covered companies against the systemic risk that comes with the interconnectedness of short-term financing positions secured by level 1 liquid assets, such as Treasury securities and reverse repos.

“The better approach was taken in the NPR,” he said. “[It] would have imposed a modest but important stable funding obligation on these activities, which have proven, by experience, to be subject to volatility. Otherwise these large banks are freed from any obligation to take responsibility for the liquidity risks of these activities.”

“The entire risk is effectively transferred to the public sector through the Federal Reserve. That defeats the purpose of the net stable funding ratio requirement,” he added.

The Bank Policy Institute (BPI), a self-described frequent critic of the NSFR, said in September it would be “reckless” to adopt the original version, arguing the rules needed to be “rethought”. 

In a report, BPI chief economist Bill Nelson says the original rule would have made it even harder for banks to contribute liquidity to Treasury markets under strain.

“It would have made the September 2019 episode of repo market volatility and the March 2020 episode of Treasury market volatility – when the financial system walked up to the edge of catastrophe – worse.”

Randal Quarles, the Fed’s vice chair of supervision, said the final rule simply tailors the stringency of the requirements based on a bank’s risk profile.

But Gruenberg argued that the new rule overlooks the financial stability risks posed by regional banks in the US. “Subjecting them to a reduced or no NSFR requirement, as this final rule would do, seriously undermines the purpose of the rule.”

Fed governor Lael Brainard – who has recently been the focus of speculation as a potential Treasury secretary in a Biden administration – also dissented, saying that the final NSFR rule “goes beyond the statutory requirements and weakens the NSFR relative to the proposed rule.”

“A small RSF requirement is warranted to mitigate systemic fire-sale risks and reduce the need for central bank emergency intervention at times of stress,” she added.

With the US presidential election looming, it is unlikely that the NSFR rules will be revisited soon even if there is a change in political administration, according to Randy Benjenk, a partner at Covington & Burling in Washington, DC.

“The NSFR has not been as big of a political focus as other prudential rules, and it is likely the next set of agency leaders under any administration would first comprehensively review the capital and liquidity rules enacted in the last five to 10 years as a whole, taking into account how they are changing bank behaviour,” he tells GBRR.

Gruenberg and Brainard also recently both opposed measures allowing banks to make higher capital distributions under stressed financial conditions. They are the sole Democrats on the FDIC and Federal Reserve boards respectively.

Brainard’s opposition to the NSFR final rule marks the tenth time she has dissented in a Federal Reserve board vote in 2020.

The Federal Reserve, FDIC and OCC also voted on 20 October to strengthen a bailout-prevention rule that will penalise major banks for buying total loss-absorbing capacity (TLAC) debt.

It says this will limit the consequences on the US financial system in the event a major bank fails.

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