July 6, 2016 Liquidity Rules Now the Binding Constraint for Large Banks Challenges for Large Banks Create Opportunities for Regional and Community Banks Thomas W. Killian, Principal (212) 466-7709 [email protected]On June 23rd all 33 U.S. bank holding companies with $50 billion or more in assets passed the quantitative component of the Federal Reserve Board’s 2016 Comprehensive Capital and Analysis Review (CCAR) severely adverse case stress test with more than sufficient capital above required minimum levels. 1 On June 29 th , 31 of these banks also passed the qualitative component of the CCAR stress test. 2 For these large banks attention has now shifted to liquidity as the binding constraint in planning. The liquidity requirements for large banks are being finalized with comments due on August 5 th for the Net Stable Funding Ratio (NSFR). 3 Once the NSFR is completed, large U.S. bank holding companies with $50 billion or more in assets will have four overlapping and interrelated liquidity requirements consisting of the: Liquidity Coverage Ratio Net Stable Funding Ratio Method 2 GSIB Capital Buffer Comprehensive Liquidity Assessment and Review With the NSFR as the final piece of the liquidity requirement puzzle soon falling into place, bank management teams and Boards of Directors, along with bank equity and debt investors are now taking a fresh look at the challenges for these large banks and specifically for the eight global systemically important banks (GSIBs) 4 and the opportunities for regional and community banks not subject to these 1 Dodd-Frank Act Stress Test 2016: Supervisory Stress Test Methodology and Results. Board of Governors of the Federal Reserve System. June 2016. Page 13. 2 Comprehensive Capital Analysis and Review 2016: Assessment Framework and Results, Board of Governors of the Federal Reserve System. June 2016. Page 14. (Please see Appendix A for more details on the results of the CCAR stress tests.). 3 Notice of Proposed Rulemaking. Net Stable Funding Ratio: Liquidity Risk Measurement Standards and Disclosure Requirements. Office of the Comptroller of the Currency (OCC), Department of the Treasury, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation. Page 13. 4 Current GSIBs include Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., The Goldman Sachs Group, Inc., JP Morgan Chase & Co., Morgan Stanley, State Street Corporation and Wells Fargo & Company.
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July 6, 2016
Liquidity Rules Now the Binding Constraint for Large Banks
Challenges for Large Banks Create Opportunities for Regional and Community Banks
On June 23rd all 33 U.S. bank holding companies with $50 billion or more in assets passed the quantitative
component of the Federal Reserve Board’s 2016 Comprehensive Capital and Analysis Review (CCAR)
severely adverse case stress test with more than sufficient capital above required minimum levels. 1 On June
29th, 31 of these banks also passed the qualitative component of the CCAR stress test. 2 For these large
banks attention has now shifted to liquidity as the binding constraint in planning.
The liquidity requirements for large banks are being finalized with comments due on August 5 th for the Net
Stable Funding Ratio (NSFR).3 Once the NSFR is completed, large U.S. bank holding companies with $50
billion or more in assets will have four overlapping and interrelated liquidity requirements consisting of the:
Liquidity Coverage Ratio
Net Stable Funding Ratio
Method 2 GSIB Capital Buffer
Comprehensive Liquidity Assessment and Review
With the NSFR as the final piece of the liquidity requirement puzzle soon falling into place, bank
management teams and Boards of Directors, along with bank equity and debt investors are now taking a
fresh look at the challenges for these large banks and specifically for the eight global systemically
important banks (GSIBs)4 and the opportunities for regional and community banks not subject to these
1 Dodd-Frank Act Stress Test 2016: Supervisory Stress Test Methodology and Results. Board of Governors of the Federal Reserve System. June2016. Page 13.2
Comprehensive Capital Analysis and Review 2016: Assessment Framework and Results, Board of Governors of the Federal Reserve System.June 2016. Page 14. (Please see Appendix A for more details on the results of the CCAR stress tests.).3 Notice of Proposed Rulemaking. Net Stable Funding Ratio: Liquidity Risk Measurement Standards and Disclosure Requirements. Office of theComptroller of the Currency (OCC), Department of the Treasury, Board of Governors of the Federal Reserve System, and the Federal DepositInsurance Corporation. Page 13.4
Current GSIBs include Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., The Goldman Sachs Group, Inc.,JP Morgan Chase & Co., Morgan Stanley, State Street Corporation and Wells Fargo & Company.
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liquidity requirements.5 This note will provide an overview of each of these liquidity requirements, outline
the applicability of each based primarily on asset size, and discuss the interplay and overlap between the
rules and the timeline for full implementation. In conclusion, we will provide recommendations of funding,
investment and lending opportunities for regional and community banks with less than $50 billion in assets
that may be attractive given the liquidity constraints faced by large banks.
As shown in Chart A below, each of the four liquidity requirements has a distinctly different measurement
period, calculation methodology and penalty for non-compliance. The Liquidity Coverage Ratio (LCR) or
Modified LCR captures 30-day or less liquidity risk under normal risk scenarios. The Comprehensive
Liquidity Assessment and Review (CLAR) captures liquidity risk based on each financial institution’s unique
stress scenarios which are compared across all 16 firms 6 consisting of U.S. GSIBs, U.S. systemically
important insurance companies, and international broker dealers with a significant U.S. presence covered
by the Large Institution Supervision Coordinating Committee (LISCC).7 The Method 2 GSIB buffer (Method 2
Buffer) measures wholesale funding reliance using an asset weighting based on risk profile, which is
distinctly different from the Method 1 GSIB buffer that focuses on broader systemic risks. The NSFR
captures longer term funding risk with asset and liability weighting based on time periods ranging from
overnight, 30 days or less, more than 30 and less than 6 months, 6 months to one year, and permanent.
Non-compliance with these regulations triggers adverse consequences that range from the requirement to
immediately file a plan showing steps to reach compliance with the LCR and NSFR, to supervisory sanctions
and CAMELS rating downgrade under CLAR, to potential additional common equity tier 1 capital
requirements under the Method 2 Buffer.
Chart A: Summary of Liquidity Regulations
Source: Federal Reserve Board
5 Please see Appendix B for a Glossary of Key Terms related to these liquidity requirements for U.S. banks.6 Supervision and Regulation Letter SR 15-7. April 17, 2015.7
Current LISCC portfolio firms include the GSIBs listed in note 4 and American international Group, Inc., Barclays PLC, Credit Suisse Group AG,Deutsche Bank AG, General Electric Capital Corporation, MetLife, Inc., Prudential Financial, Inc., and UBS AG.
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Compliance with these liquidity requirements has historically been considered less burdensome than the
Basel III capital requirements. This changed when the Fed implemented the requirement to classify
commercial deposits as either operating or non-operating under the Method 2 Buffer calculation
announced in July 2015. Operating deposits8 require quantitative documentation of their use to support
transaction activity and are assumed to be very stable with little need for liquidity coverage. All other cash
deposits are classified as non-operating deposits that are assumed to be highly unstable and must be
covered by high quality liquid assets (HQLA)9 which generally have a lower yield. As a result, the return on
investment for deploying non-operating deposits is much lower than the return potential for operating
deposits which do not require coverage by HQLA and can be invested in much higher yielding investments
and loans. JP Morgan served notice of the importance of this change in liquidity measurement with their
more than $200 billion reduction in non-operating deposits at year-end 2015. Overall, in 2015, the U.S
GSIBs were estimated to have proactively pushed nearly $400 billion in non-operating deposits off their
balance sheets.
Liquidity management is now viewed as a bigger challenge to their business than Basel III capital rules,
according to large bank CEOs participating in the Board’s February meeting of the Federal Advisory Council.
“Liquidity rules require banks to put a high amount of liquidity aside for commercial deposits and will raise
the cost of credit on a systemic basis, impeding long-term economic growth. By devaluing the deposits
that commercial customers provide, more deposits are being pushed off bank balance sheets into off-
balance-sheet funds.” 10 Large, commercially-oriented institutions with a lower percentage of retail
deposits than competitors will be most impacted. This could create a significant market opportunity for
regional and community banks (not subject to these liquidity requirements) to offer expansive depository
services to commercial accounts that will be looking for new banking relationships.
The timing for the effectiveness of liquidity regulation is coming quickly with full phase-in of the LCR
effective January 1, 2017. The CLAR is already in place and being implemented on a confidential basis with
the 16 LISCC supervised institutions. As highlighted below in Chart B, the NSFR is expected to become
effective in 2018 while the Method 2 Buffer phases-in to be fully effective in 2019.
8Operating deposits include deposits from bank clients with a substantive dependency on the bank where deposits are required for certain
activities (i.e. clearing, custody or cash management activities). Non-operating deposits are all other unsecured wholesale deposits, bothinsured and uninsured. (See Appendix C for more details on the requirements for operating deposits.)9 Guidance and Templates Regarding Liquidity Coverage Ratio Disclosure Standards. http://www.sama.gov.sa/en-US/Laws/Documents/Section%20B/4.%20BCBS%20Document%20regarding%20Liquidity%20Coverage%20Ratio%20Disclosure%20Standards.pdf10
Record of Meeting. Federal Advisory Council and Board of Governors. Wednesday, February 3, 2016. Page. 12.
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Chart B: Timing for Phase-in of Liquidity Regulations
Source: Federal Reserve Board
With this background, and the swift change in funding approach applied by the GSIB banks starting in
2015, this paper will focus on the four key regulatory measures of liquidity for the large banks and GSIBs
and potential opportunities for regional and community banks with liquidity, investments and loans.
Liquidity Coverage Ratio and Modified LCR
The Liquidity Coverage Ratio (LCR) was first introduced in 2010 and later refined and adopted in 2014.
This liquidity requirement is designed to address short term liquidity needs of 30 days or less and applies
to all Bank Holding Companies (BHCs) including GSIBs, Savings and Loan Holding Companies (S&Ls) and
State Member Banks with $250 billion or more in total consolidated assets or $10 billion or more in on-
balance sheet foreign exposure (Covered Banks).
Covered Banks are required to keep a stock of HQLAs sufficient to cover the largest net cash outflow in any
30-day period under stress scenarios. Cash outflows are those related to deposits, unsecured wholesale
funding, secured funding, lending commitments, repo liabilities and collateral posting.
Chart C below highlights the categories of HQLAs that are measured daily and must always meet or exceed
100% of the cash outflows, also listed below. A maximum of 75% of cash outflows can be offset by cash
inflows. Therefore, the minimum size of the high-quality liquid asset buffer is 25% of stressed cash
outflows.
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Chart C: Liquidity Coverage Ratio (LCR)
Source: Federal Reserve Board
In meeting the LCR, at least 60% of the HQLAs maintained by Covered Banks must be Level 1 assets with a
maximum of 40% Level 2 assets permitted as described below in Chart D:
Chart D: Components of HQLA
Source: Federal Reserve Board
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After industry pressure, the regulators recently agreed to permit investment grade rated general obligation
bonds issued by Public Sector Entities (PSEs) to be included in Level 2B assets but limited the amount to 5%
of total HQLA and with any single issuer limited to 2 times average daily trading volume.
As shown below in Chart E, aside from cash and U.S. Treasury securities, GNMA securities are the most
attractive to meet the HQLA requirements with 0% haircut to fair value and 100% inclusion in HQLA. FNMA
and FHLMC securities each have a 15% haircut with a maximum of 40% inclusion in HQLA. Investment
grade corporate debt and general obligation muni debt have a 50% haircut of fair value with 15% and 5%
inclusion in HQLA. Non-agency RMBS and non-investment grade municipal bonds are excluded from
HQLA.
Chart E: HQLA Haircuts and Inclusion Percentages
Source: Federal Reserve Board
BHCs and S&Ls with $50 billion or more in total consolidated assets but less than $250 billon are subject to
a modified version of the LCR (Modified LCR). These banks are required to keep a stock of HQLA that is
sufficient to cover 70% of the largest net cash outflow in any 30-day stress period.
Banks with total assets of less than $50 billion are not subject to the LCR or Modified LCR and have
substantial flexibility to meet the Dodd-Frank Act (DFA) liquidity requirements without haircuts on fair
value or limits for inclusion in liquidity.
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Net Stable Funding Ratio and Modified NSFR
With a focus on a one-year timeframe, the NSFR is being designed to complement the short-term 30-day
focus of the LCR. The NSFR was first introduced in 2010, revised in 2014, and is now being finalized with
the request for comments due on August 5, , 2016. The NSFR is expected to become effective on January 1,
2018. As of December 31, 2015, the regulatory agencies estimate that the NSFR would apply to 15 bank
holding companies with $250 billion or more in assets and a modified version of the NSFR (Modified NSFR)
would apply to the 20 bank holding companies with $50 billion or more in total consolidated assets but
less than $250 billion. The agencies estimate that these 35 institutions would need to raise approximately
$39 billion in Available Stable Funding (ASF).11
As currently proposed, the NSFR requires Covered Banks to maintain an amount of ASF consisting of
capital, deposits, wholesale funding and other liabilities and including net payables on derivatives to more
than offset the required stable funding needs of the institution over a period of one year. BHCs subject to
the Modified NSFR must keep ASF to meet 70% of RSF.
The current proposal mandates that ASF is calculated by first determining the carrying value or book value
of the Covered Bank’s capital and liabilities. This value is then multiplied by a factor that weighs the
likelihood of the source of funds being available based on BIS and U.S. regulatory guidelines. The ASF
amount is the sum of the weighted amounts. Chart F below summarizes the key sources of AFS and the
weighting factors assigned to each. Note that non-operational deposits, highlighted in red, provide NO AFS
support thus reinforcing the difficulty with Covered Banks continuing to provide this deposit service.
Chart F: Sources of Available Stable Funding and Weighting Factors
Source: Federal Reserve Board and the Basel Committee on Banking Supervision
11 Notice of Proposed Rulemaking. Net Stable Funding Ratio: Liquidity Risk Measurement Standards and Disclosure Requirements. May 3,2016. Office of the Comptroller of the Currency, Department of the Treasury, Board of Governors of the Federal Reserve System, and FederalDeposit Insurance Corporation. Page 145.
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The required stable funding (RSF) amount is calculated by first identifying the carrying value or book value
of the Covered Bank’s assets and off-balance-sheet liabilities. These values are then multiplied by a factor
that weighs the likelihood of the use of funds being needed based on BIS and U.S. regulatory guidelines.
The RSF amount is the sum of the weighted amounts. Chart G below summarizes the key uses of RSF and
the weighting factors assigned to each.
Chart G: Uses of Required Stable Funding and Weighting Factors
Source: Federal Reserve Board and the Basel Committee on Banking Supervision
Note that the RSF relies on the definitions of Level 1, Level 2A and Level 2B assets from the LCR. There is
also a significant distinction in the RSF calculation required for different types of lending. Low risk-
weighted loans to retail customers and small and medium-sized enterprises with a remaining maturity of
one year or less require a 50% RSF factor. Residential mortgages and other unencumbered performing
loans with a remaining maturity of one year or more require a 65% RSF factor. All other assets, including
loans to financial institutions, encumbered assets and project finance loans with a maturity greater than
one year require a RSF factor of 100%. Similarly, off-balance sheet committed and non-cancellable lines of
credit have 100% RSF and require sufficient ASF to cover the potential draw down under the commitment.
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BHCs subject to the NSFR and the Modified NSFR may have an incentive to reduce long-term lending for
loans with risk weightings greater than 35% and a RSF factor of 85% or more. As a result, the NSFR rules
may create long-term lending opportunities for regional and community banks that are not subject to the
NSFR or Modified NSFR.
Method 2 Buffer
In 2010, the BIS introduced an additional common equity tier 1 (CET1) capital cushion ranging from 1.0% to
2.5% for BHCs greater than $250 billion in assets that have been identified as GSIBs by the Financial
Stability Board (FSB). The exact cushion is set by the FSB based on the GSIB’s ratings across five categories
of risk, all equally weighted at 20%. These categories are size, interconnectedness, substitutability,
complexity, and cross-jurisdictional activity. The top 75 global institutions are selected as GSIBs annually
using the Method 1 weighting shown below in Chart H. While this methodology is used to select the GSIBs
and apply a CET1 buffer from 1.0% to 2.5%, the U.S. regulatory agencies did not feel that this Method 1
buffer provided sufficient protection against reliance on wholesale funding and illiquidity of investments.
To address this concern, in 2015 the U.S. regulatory agencies introduced the Method 2 Buffer with a capital
cushion ranging from 1.0% to 4.5% that (i) replaced the category of substitutability with reliance on short-
term wholesale funding (STWF), (ii) reduced the weighting for size and cross-jurisdictional activity, and (iii)
dramatically increased the weighting for STWF and investment in Level 3 assets along with trading and
available for sale securities.
Chart H: Method 1 vs. Method 2 Categories and Weightings
Source: Federal Reserve Board and Basel Committee on Banking Supervision
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The Method 2 Buffer heavily penalizes reliance on STWF, which is calculated as weighted average short-
term wholesale funding / risk weighted assets x 350. With these changes in calculation methodology the
typical basis point range of GSIB scores increased from 130 to 729 under Method 1 to 130 to 929 under
Method 2.
The July 2015 calculation of the Method 1 and Method 2 Buffer amounts shown below in Chart I illustrate
the significant penalty that JPM, C, GS, MS and BAC would be required to pay for their higher reliance on
wholesale funding and investment in illiquid securities. JPM’s 4.50% Method 2 surcharge represented 200
basis points of additional CET1 it would be forced to add over the Method 1 surcharge amount, a
substantial penalty relative to peers. By year-end 2015, JPM had reduced their Method 2 buffer from 4.5%
to 3.5% by reducing non-operating deposits by more than $200 billion, decreasing Level 3 assets, and
reducing OTC derivatives.12
Chart I: Method 1 vs Method 2 GSIB Buffer Amounts as of July 2015
Source: Federal Reserve Board
Clearly, the weightings assigned to STWF, Level 3 assets and trading and available for sale securities in the
Method 2 calculation provide a strong capital incentive for the GSIBs to avoid reliance on wholesale funding
and non-operating deposits and investing in less liquid assets. As illustrated below in Chart J, the
weighting factors for unsecured wholesale funding range from 25% to 100% for remaining maturities of less
than 30 days to up to 365 days. These weightings significantly gross up the STWF score with the results