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Liquidity Coverage Ratio: Treatment of U.S. Municipal Securities as High-Quality Liquid Assets

As described in more detail below, this proposed rule would include limited amounts of U.S. general obligation municipal securities as level 2B liquid assets under the LCR if the securities meet certain criteria. The Board invites comment on all aspects of the proposal including whether these criteria and limitations are appropriate, reasonable, and achieve their intended purposes.
The Board proposes to include U.S. general obligation municipal securities as level 2B liquid assets, rather than as level 2A liquid assets. Municipal securities are less liquid than assets that are included as level 2A liquid assets. For example, the daily trading volume of securities issued or guaranteed by U.S. GSEs far exceeds that of U.S. municipal securities.
As a threshold matter, to qualify as HQLA under the proposal, U.S. general obligation municipal securities must be liquid and readily marketable and meet other criteria consistent with the criteria for corporate debt securities that are included as level 2B liquid assets. These criteria help to ensure comparable treatment between U.S. general obligation municipal securities and corporate debt securities included as HQLA.
[8]

In addition, to help ensure sufficient liquidity of the U.S. general obligation municipal securities that are included in the total HQLA amount, this proposed rule would impose certain limits on the amount of U.S. general obligation municipal securities that a Board-regulated institution may include as eligible HQLA.
[9]

This proposed rule would not limit the amount of U.S. municipal securities a Board-regulated institution could hold for other purposes.

A. Criteria for Inclusion as Level 2B Liquid Assets
1. U.S. General Obligation Municipal Securities
Under this proposed rule, U.S. municipal securities would qualify as HQLA only if they are general obligations of the issuing entity. General obligations of U.S. public sector entities, which include bonds or similar obligations that are backed by the full faith and credit of the public sector entities, are assigned a 20 percent risk weight under the Board’s risk-based capital rules.
[10]

This provision, which is consistent with the Basel III Liquidity Framework, is designed to limit the liquidity and credit risk associated with U.S. municipal securities included in the HQLA amount.

Revenue obligations, which include bonds or similar obligations that are obligations of U.S. public sector entities, but which the public sector entities have committed to repay with revenues from a specific project rather than from general tax funds, are assigned a 50 percent risk weight under the Board’s risk-based capital rules.
[11]

Revenue obligations are assigned a higher risk weight than general obligations because repayment of revenue obligations is dependent on revenue from an underlying project without an obligation from a public sector entity to repay these obligations from other revenue sources.
[12]

The Board has proposed to exclude revenue obligations because, during a period of significant stress, revenue derived from a particular project, such as a stadium, may fall dramatically as domestic consumption declines and the associated revenue bond may experience significant price declines and become less liquid.

2. Investment Grade U.S. General Obligation Municipal Securities
Consistent with the requirements for corporate debt securities included as level 2B liquid assets, this proposed rule would require that U.S. general obligation municipal securities be “investment grade” under 12 CFR part 1 as of the calculation date.
[13]

This criterion requires an issuer of a U.S. general obligation municipal security to have adequate capacity to meet its financial commitments under the security for the projected life of the security, which is met by showing a low risk of default and an expectation of the timely repayment of principal and interest.

3. Proven Record as a Reliable Source of Liquidity
Consistent with the requirements for corporate debt securities included as level 2B liquid assets under the LCR, this proposed rule would require that U.S. general obligation municipal securities included as level 2B liquid assets be issued by an entity whose obligations have a proven record as a reliable source of liquidity in repurchase or sales markets during a period of significant stress. A Board-regulated institution would be required to demonstrate this record of liquidity reliability and lower volatility during periods of significant stress by showing that the market price of the U.S. general obligation municipal securities or equivalent securities of the issuer declined by no more than 20 percent during a 30 calendar-day period of significant stress, or that the market haircut demanded by counterparties to secured lending and secured funding transactions that were collateralized by such debt securities or equivalent securities of the issuer increased by no more than 20 percentage points during a 30 calendar-day period of significant stress. This percentage decline in value and percentage increase in haircut is the same as those applicable to corporate debt securities included as level 2B liquid assets under the LCR.

[14]

This limitation is meant to exclude volatile U.S. municipal securities because their volatility indicates these assets may not hold their value during a period of significant stress, thereby over-estimating the amount of HQLA actually available to the banking entity.

As discussed in the Supplementary Information section to the LCR final rule, a Board-regulated institution may demonstrate a historical record that meets this criterion through reference to historical market prices and available funding haircuts of the U.S. general obligation municipal security during periods of significant stress, such as the 2007-2009 financial crisis.
[15]

Board-regulated institutions should also look to other periods of systemic and idiosyncratic stress to see if the asset under consideration has proven to be a reliable source of liquidity. As noted above, HQLA include only those assets that have demonstrated an ability to maintain relatively stable prices such that they can be rapidly sold by a Board-regulated institution to meet its obligations during a period of significant stress.

4. Not an Obligation of a Financial Sector Entity or Its Consolidated Subsidiaries
Under this proposed rule, U.S. general obligation municipal securities would qualify as HQLA only if they are not obligations of a financial sector entity and not obligations of a consolidated subsidiary of a financial sector entity. For purposes of this provision, the Board considers a security that is issued or guaranteed by a financial sector entity to be an obligation of the financial sector entity. The LCR defines a financial sector entity to include a regulated financial company, investment company, non-regulated fund, pension fund, investment adviser, or a company that the Board has determined should be treated the same as the foregoing for the purposes of the LCR. Thus, if a bond insurer insures the general obligation municipal securities of a U.S. public sector entity (such insurance is commonly referred to as a “wrap”), the securities would not be eligible for inclusion in HQLA. The Board has proposed to include this criterion in order to exclude U.S. general obligation municipal securities that are valued, in part, based on guarantees provided by financial sector entities, because these financial sector entity guarantees could exhibit similar risks and correlation with Board-regulated institutions (wrong-way risk) during a liquidity stress period, thus overestimating the amount of HQLA that would be available to the banking entity during a liquidity stress period. This criterion is consistent with the Basel III Liquidity Framework and with the requirements imposed on corporate debt securities and publicly traded common equity shares that are included as level 2B liquid assets under the LCR.

1. How should the Board supplement or amend the proposed criteria for including U.S. general obligation municipal securities as HQLA?

2. Is it appropriate to exclude U.S. general obligation municipal securities that are guaranteed (or “wrapped”) by bond insurers or other financial sector entities from HQLA because of wrong-way risk? Why or why not? How else could the Board address concerns regarding the wrong-way risk associated with such securities?

B. Limitations on a Company’s Inclusion of U.S. General Obligation Municipal Securities as Eligible HQLA
This proposed rule would limit the amount of U.S. general obligation municipal securities a Board-regulated institution could include as eligible HQLA based on the total amount outstanding of U.S. general obligation municipal securities with the same CUSIP number, on the average daily trading volume of general obligation municipal securities issued by a particular U.S. municipal issuer, and on a percentage of the institution’s total HQLA amount. These limitations are intended to address the unique structure of the U.S. municipal securities market and designed to help ensure sufficient liquidity of the U.S. general obligation municipal securities included in the HQLA amount under the LCR.
1. Limitation on the Inclusion of U.S. General Obligation Municipal Securities With the Same CUSIP Number as Eligible HQLA
Individual issuances of U.S. municipal securities (those with the same CUSIP number) by a single public sector entity are frequently far smaller and more numerous than issuances of debt securities by a single corporate issuer and exhibit a diverse array of maturity dates and interest rates. This is in part due to legal and other restrictions on the size of individual issuances by public sector entities and because U.S. municipal securities are frequently marketed to retail or smaller institutional investors. For example, a very large issuer of U.S. municipal securities (such as a state or large city) may have several hundred individual issuances outstanding. In contrast, a single corporate issuer may have a comparable dollar amount of securities outstanding but with only 20 to 30 individual issuances outstanding. Investors in U.S. municipal securities sometimes purchase a large percentage, including more than 50 percent of the outstanding amount, of the individual issuance.
The Board is concerned that a Board-regulated institution would not be able to monetize a concentration in the holding of a particular issuance of U.S. general obligation municipal securities during a period of significant stress without a material impact on the securities’ price. This proposed rule therefore would permit a Board-regulated institution to count U.S. general obligation municipal securities as eligible HQLA only to the extent the fair value of the institutions’ securities with the same CUSIP number do not exceed a maximum of 25 percent of the total amount of outstanding securities with the same CUSIP number. Under the proposal, this threshold for inclusion as eligible HQLA would be calculated prior to application of the 50 percent haircut applicable to level 2B liquid assets that is set forth in § 249.21(a)(3) of the LCR final rule. This requirement is designed to ensure that a Board-regulated institution does not include in its HQLA amount a concentration of an individual issuance of U.S. general obligation municipal securities.
2. Limitation on the Inclusion of the U.S. General Obligation Municipal Securities of a Single Issuer as Eligible HQLA
The Board is proposing a limit on the amount of securities issued by a single U.S. public sector entity that a Board-regulated institution may include as eligible HQLA, based on the trading volume that the secondary market for the entity’s general obligation municipal securities could be expected to withstand before prices materially decline. For each U.S. public sector entity, this proposed rule would limit the aggregate fair value of the general obligation securities that a Board-regulated institution could include as eligible HQLA to two times the average daily trading volume, as measured over the previous four quarters, of all general obligation municipal securities issued by that public sector entity.

The LCR was designed to include as eligible HQLA assets that remain relatively liquid and have multiple buyers and sellers during periods of significant stress, as a covered company may be expected to sell HQLA to meet its cash outflows during such periods. To remain consistent with the design of the LCR, the proposal seeks to include U.S. general obligation municipal securities as eligible HQLA to the extent that they would exhibit liquidity without dramatic loss in value during periods of significant stress. The U.S. municipal securities market includes a large diversity of issuers, size of issuances, and volumes of secondary market trading. The Board analyzed data on the historical trading volume of municipal securities in order to determine the general level of increased sales of municipal securities that could be absorbed by the market during periods of significant stress before prices would materially decline. The proposal would limit the aggregate fair value of the U.S. general obligation municipal securities of a public sector entity that may be included as eligible HQLA to two times the average daily trading volume of all U.S. general obligation municipal securities issued by that public sector entity because, based on the Board’s analysis, a holding of two times the average daily trading volume could likely be absorbed by the market within a 30 calendar-day period of significant stress without materially disrupting the functioning of the market.
Rather than proposing an average daily trading volume limitation on a per-security basis, the Board is proposing a limitation based on the average daily trading volume of all U.S. general obligation municipal securities issued by the public sector entity. Due to the smaller size of many U.S. municipal securities issuances, applying this limit on a per-security basis may unnecessarily restrict a covered company’s ability to invest in a particular security that meets the Board-regulated institution’s investment criteria and liquidity needs. However, as discussed above, the Board has proposed a separate limitation on the amount of an individual issuance that may be included as eligible HQLA to address the concern that a high concentration of an individual U.S. general obligation municipal security could be included as eligible HQLA.
3. Limitation on the Amount of U.S. General Obligation Municipal Securities That Can Be Included in the HQLA Amount
The Board is proposing to limit the amount of U.S. general obligation municipal securities that are included in a Board-regulated institution’s HQLA amount to no more than five percent of its total HQLA amount. This limit is in addition to the 40 percent limit on the aggregate amount of level 2A and level 2B liquid assets and the 15 percent limit on level 2B liquid assets that can be included in the HQLA amount. It also complements the other two limits on U.S. general obligation municipal securities described above, which relate solely to a particular issuance and individual issuers. Although the Board has concluded that certain U.S. general obligation municipal securities are sufficiently liquid to be included as eligible HQLA, the Board proposes to limit the aggregate amount of all U.S. general obligation municipal securities that may be included in the HQLA amount to ensure appropriate diversification of asset classes within a Board-regulated institution’s HQLA amount. Consistent with the LCR’s limits on level 2A and level 2B liquid assets, this proposed five percent limit applies both on an unadjusted basis and after adjusting the composition of the HQLA amount upon the unwind of certain secured funding transactions, secured lending transactions, asset exchanges and collateralized derivatives transactions.
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The proposed five percent limit would be applied to the calculation of the HQLA amount by amending the definitions of the unadjusted excess HQLA amount and the adjusted excess HQLA amount.
[17]

Under this proposed rule, the unadjusted excess HQLA amount would equal the sum of the level 2 cap excess amount, the level 2B cap excess amount and the public sector entity security cap excess amount. The method of calculating the public sector entity security cap excess amount is set forth in § 249.21(f) of this proposed rule. Under this provision, the public sector entity security cap excess amount would be calculated as the greater of: (1) The public sector entity security liquid asset amount minus the level 2 cap excess amount minus level 2B cap excess amount minus 0.0526 (or 5/95, which is the ratio of the maximum allowable public sector entity security liquid assets to the level 1 liquid assets and other level 2 liquid assets) times the sum of (i) the level 1 liquid asset amount, (ii) the level 2A liquid asset amount, and (iii) the level 2B liquid asset amount minus the public sector entity security liquid asset amount; or (2) zero.

Under this proposed rule, the adjusted excess HQLA amount would equal the sum of the adjusted level 2 cap excess amount, the adjusted level 2B cap excess amount, and the adjusted public sector entity cap excess amount. The method of calculating the adjusted public sector entity security cap excess amount is set forth in § 249.21(k) of this proposed rule. Under this provision, the adjusted public sector entity security cap excess amount would be calculated as the greater of: (1) The adjusted public sector entity security liquid asset amount minus the adjusted level 2 cap excess amount minus the adjusted level 2B cap excess amount minus 0.0526 (or 5/95, which is the ratio of the maximum allowable adjusted public sector entity security liquid assets to the adjusted level 1 liquid assets and other adjusted level 2 liquid assets) times the sum of (i) the adjusted level 1 liquid asset amount, (ii) the adjusted level 2A liquid asset amount, and (iii) the adjusted level 2B liquid asset amount minus the adjusted public sector entity security liquid asset amount; or (2) zero.

3. What additional or alternative limitations should the Board consider relating to the inclusion of individual and aggregate issuances of U.S. public sector entities as eligible HQLA and in a Board-regulated institution’s HQLA amount? How else could the Board address concerns regarding concentrations and minimizing market price movements associated with sales of HQLA?


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