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Banks Face New Liquidity Rule: Lending to Feel Pain?

Zacks Equity Research

Adding to already stringent capital regulations, U.S. banks now face another rule, which may hamper their lending activities to some extent. The Federal Reserve, along with the Federal Deposit Insurance Corp. (:FDIC) and the Office of the Comptroller of the Currency (OCC), has approved the new liquidity rule.

The new rule will ensure that banks do not face liquidity crunch during any financial crisis, so that the 2008 disaster does not recur. First proposed in Oct 2013, the rule also meets the requirements of the Dodd-Frank Wall Street Reform and the Consumer Protection Act.

The Rule

Per the Liquidity Rule, big banks (with at least $250 billion in total assets or $10 billion of foreign exposure) must hold high quality liquid assets (:HQLA) that can be easily converted in cash that is equal to or greater than the amount required to run their operations for 30 days in the event of a financial crisis. Starting the phase-in from Jan 1, 2015 the banks must be fully compliant by 2017, and calculate their liquidity on a daily basis.

Further, the rule requires even the comparatively smaller banks (with total assets of at least $50 billion) to hold HQLA that can be used for 21 days. These banks will start phase-in from Jan 1, 2016 and will get two years to fully comply with the rule, calculating liquidity on a monthly basis.

Central bank reserves as well as government and corporate debt form part of HQLA. However, municipal bonds are excluded from HQLA as of now, although regulators are reconsidering the proposal to include the same (read more: Municipal Bonds to Lose Liquid-Asset Status? 2 Banks to Avoid).

The Federal Reserve defined liquidity coverage ratio (:LCR) to be the banks’ liquid assets, as a percentage of projected net cash outflows at the time of cash crunch.

Separately, the regulators are also seeking comments on a proposal to determine margin requirements for swap trades. The main aim of the rule is to lower risky trades that might trigger another financial crisis.

Impacted Institutions

Banks, on the whole, as per the regulators, will be required to set aside an estimated $2.5 trillion in HQLA. At the same time, the Federal Reserve anticipates nearly 70% of the banks (requiring implementation) to have already met the criteria, albeit a shortfall of nearly $100 billion.

Big banks including JPMorgan Chase & Co. (JPM), Bank of America Corporation (BAC), Citigroup Inc. (C), The PNC Financial Services Group, Inc. (PNC) and Wells Fargo & Company (WFC) would be subjected to strict regulations. Further, 20 smaller banks are also expected to be impacted.

According to the first-quarter data, banks such as JPMorgan, BofA and Wells Fargo, among others, already meet these requirements. Moreover, Morgan Stanley (MS) and The Goldman Sachs Group, Inc. (GS) fulfill LCR ratio. We believe that many other banks must have added HQLA to their balance sheets during the second quarter so as to comply with the new rule.

Nonetheless, the rule does not apply to non-bank financial institutions that have been designated as systematically important by the Financial Stability Oversight Council, such as American International Group, Inc. (AIG) and GE Capital. Also, the U.S. banking units of foreign banks are not required to follow this rule. The regulators will possibly devise a separate rule for these institutions.

Road Ahead

The primary purpose of the liquidity rule is to make sure that banks are self-sufficient to meet their cash requirements during a financial crisis. This would also entail less involvement of taxpayers’ money for the bailout of troubled financial institutions.

On the downside, the HQLA generate very low return and to offset this, banks will likely invest in high-yield loans and securities that are deemed to be moderately risky. Further, the rule is expected to limit the flexibility of banks with respect to investments and lending volumes. Besides, such stringent capital rules may (to an extent) slacken the pace of a worldwide economic recovery in the near term.

Overall, structural changes in the banking sector will continue to impair business expansion. Several dampening factors – asset-quality troubles, mortgage liabilities and tighter regulations – will decide the fate of the U.S. banks in the quarters ahead. However, conformity to the new capital regime will ensure long-term stability and security for the industry.

Read the Full Research Report on JPM
Read the Full Research Report on PNC
Read the Full Research Report on AIG
Read the Full Research Report on MS
Read the Full Research Report on WFC
Read the Full Research Report on C
Read the Full Research Report on GS
Read the Full Research Report on BAC


Zacks Investment Research