Federal Regulators Publish Rule to Classify Muni Bonds as High-Quality Liquid Assets

Federal banking regulators – the Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation, and the Federal Reserve – published earlier today an interim final rule changing how municipal bonds are treated under federal liquidity standards. From now on, the large banks the agencies regulate may count many of their municipal bond investments as high-quality liquid assets. The rule takes effect today, but the agencies are also seeking comment on possible adjustments.

The interim rule modifies a final rule the regulators issued jointly in October 2014 to ensure that large banks hold enough liquidity to continue making payments during periods of financial stress. Under the rule, banks with at least $250 billion in assets (or $10 billion in foreign exposure on their balance sheet) must maintain a minimum liquidity coverage ratio (LCR) composed of certain financial investments that are considered High-Quality Liquid Assets (HQLAs). The capital standards took effect on January 1, 2017.

Despite the urging of NCSHA and other advocates, the agencies did not include municipal bonds as HQLAs in their initial liquidity rule. Consequently, large banks have been prohibited from counting their municipal bond investments towards their LCRs. In response to pressure from members of Congress and advocates, the Federal Reserve amended its liquidity standards in 2016 to allow some municipal bonds to be considered as HQLAs. However, banks could only count uninsured general obligation bonds. This means that housing bonds, and other private-activity bonds, were still not considered HQLAs. Further, because the Federal Reserve made these changes unilaterally instead of jointly with Treasury and the FDIC, it applied only to the large banks the Federal Reserve oversees.

The interim rule released today implements a change to the liquidity standards authorized by Congress through comprehensive financial regulatory reform legislation passed earlier this year (the Economic Growth, Regulatory Relief, and Consumer Protection Act, S. 2155). S. 2155 directed the regulators to amend their liquidity standards to classify all investment-grade municipal bonds that are "liquid and readily marketable" as level 2b HQLAs. This applies to all municipal bonds, including private-activity Housing Bonds. NCSHA urged Congress on several occasions to enact such changes.

The level 2 classification means that banks must count such municipal bonds towards their LCRs at a discounted value. In addition, banks cannot use level 2 assets to account for more than 40 percent of their HQLAs.

For the purposes of the interim rule, a municipal bond is considered "investment grade" if the bond’s issuer has an adequate capacity to meet financial commitments under the security for the projected life of the bond. Further, a municipal bond is considered "liquid and readily marketable" if it is traded in an active secondary market with more than two committed market makers; a large number of non-market maker participants on both the buying and selling sides of transactions; timely and observable market prices; and a high trading volume.

The deadline to comment on the interim final rule is October 1.

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