Fed Begins Review of Liquidity Sources at Largest U.S. Banks

The Federal Reserve is examining liquidity at some of the largest U.S. banks as part of a new regime of stronger oversight of systemic risk, according to a person familiar with the review.

Fed supervisors are analyzing the mix of short- and long-term liabilities banks use to fund their holdings of loans and securities, the person said. The reviews also cover sources of banks’ funding and their plans for backup cash in the event of a shock.

The liquidity tests are part of the Fed’s effort to strengthen the financial system and prevent a repeat of the 2008-2009 crisis that brought down Lehman Brothers Holdings Inc. and resulted in taxpayer-funded bailouts of firms including Citigroup Inc. and Bank of America Corp.

The review, which was reported earlier by the Financial Times, involves fewer banks than the 19 undergoing separate stress tests of capital, the person said. In those tests, the Fed is seeking to determine how capital of the largest banks would hold up under various economic scenarios, including a 6.1 percent economic contraction and a jobless rate of 12.1 percent.

Fed spokeswoman Barbara Hagenbaugh declined to comment on the number of banks under review in the liquidity exam.

The Fed’s heightened interest in liquidity stems from the view of officials such as Daniel Tarullo, the governor in charge of supervision, that short-term non-deposit funding presents potential risks to the financial system. Tarullo has been persuaded in part by Yale School of Management Professor Gary Gorton’s work on the 2008-2009 crisis, which described modern-day bank runs occurring in markets for commercial paper and repurchase agreements.

Prime Funds

Fed officials were served a reminder of that risk in 2010. U.S. prime money-market funds by the end of March that year had about $493 billion of certificates of deposit, commercial paper and asset-backed commercial paper from euro-region financial firms, according to a JPMorgan Chase & Co. research estimate.

As financial strains in Europe worsened, money funds shrank exposure at a pace of $54 billion a month for a total of $162 billion over April, May and June, according to JPMorgan estimates. That caused a squeeze in dollar funding markets which prompted Fed officials to re-open dollar swap lines with foreign central banks in May of that year.

At a meeting of the New York Fed’s Financial Advisory Roundtable on June 8 of this year, Darrell Duffie, a Stanford University finance professor, gave a presentation on liquidity losses at financial institutions during crises.

“Members highlighted the importance of stress testing banks’ liquidity and access to funding during adverse periods,” minutes from the meeting said.

The liquidity tests are intended to guide bank supervisors and the results won’t be made public, the Financial Times said. If a bank’s liquidity is called into question, examiners could use the results to push them to adjust their funding or increase their supply of easy-to-sell assets, it reported.

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