U.S. Bank Liquidity Rule Said to Exclude Municipal Bonds

Municipal bonds will be excluded from the group of easily sellable assets that banks can use to show they’re able to survive a credit crunch, according to a person familiar with the rule.

Regulators including the Federal Reserve are set to approve a final liquidity rule on Sept. 3. The most recent draft bars debt issued by states and municipalities from being listed as high-quality assets that could help sustain a bank through a 30-day squeeze, said the person, speaking on condition of anonymity because the process isn’t public.

Hoping to head off the kind of vulnerability seen during the 2008 credit crisis, the Fed, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. based their rule on an accord reached by the 27-nation Basel Committee on Banking Supervision. An initial version proposed last year, which called for a 2017 implementation, was toughest on banks with more than $250 billion in assets or major global reach.

Eric Kollig, a Fed spokesman, declined to comment on the final rule.

The regulations could weigh on prices in the $3.7 trillion municipal bond market by giving banks less incentive to buy bonds that finance schools, roads and public works. Fitch Ratings in January said that an exclusion could lead banks to begin cutting their holdings in the market.

Wells Tally

“Over time there would be less demand for municipal securities,” said Michael Decker, a managing director who tracks municipal securities regulations for the Securities Industry and Financial Markets Association. “The result would be higher borrowing costs for state and local governments.”

Wells Fargo & Co., based in San Francisco, held the most municipal bonds among the four largest U.S. banks, with $47.3 billion on June 30, according to regulatory filings. The bank didn’t say how much was included in its liquidity tally. Wells Fargo said in May that it was compliant with the international rule and was awaiting the U.S. version.

At their meetings next week, bank regulators are also set to vote on two other rules, said two people familiar with the planning. They will complete a rule mandating how much loss-absorbing capital must be held against a bank’s total assets. The agencies also plan to re-propose a measure on margin for non-cleared derivative transactions.

The flurry of rulemaking activity will come just before a Sept. 9 hearing of the Senate Banking Committee, where regulators will be questioned about their recent progress on implementing Dodd-Frank Act regulations, the people said.

Disappointed Cities

The liquidity rule, which could change before regulators vote next week, would disappoint banks and local governments that had argued that munis should be included.

Keeping the liquid assets narrowed to such things as Treasuries and Fed bank balances “will almost certainly decrease liquidity in asset markets disfavored by the rule,” American Bankers Association President Frank Keating wrote in an Aug. 11 letter to the agencies.

Banks in recent years have played an increasing role in the municipal market, with U.S. chartered banks boosting their holdings to $425.2 billion by the end of the first quarter, up from $221.9 billion in 2008, according to Federal Reserve figures. That helped offset a drop in demand from individual investors, who pared their holdings of munis.

Minimum Standard

The asset class should be fine for emergency liquidity because it has “high credit quality, has low historic default rates and one to which the aggregate financial sector has limited exposure,” Howard Marsh, who heads the munis division of a unit of Citigroup Inc., wrote in an April 9 letter to regulators. It also generates cash for banks in a crisis, he said.

Citigroup, which has provided more details on its compliance with the rule than rivals, would remain above the minimum standard even if municipal bonds were excluded, based on figures it provided last month.

The bank said it had $435 billion of assets at the end of June that qualified under the rule as proposed earlier, or $82 billion more than the minimum. The bank said about $16 billion of that total came from munis, asset-backed securities and corporate bonds, without specifying the amount of munis.

JPMorgan Chase & Co. and Bank of America Corp. said last month that they’re above the minimum required liquidity ratio, without saying how much of their liquid assets were munis.

Municipal Anxiety

Officials from 18 cities, including Chicago, Boston and Los Angeles, have warned regulators that excluding munis would weaken their ability to raise money. “Imposing standards against all municipal issuers that are more conservative than the international standard will hurt the real engines of the U.S. economy,” they wrote in a June 3 letter.

The municipal-bond market has seen some high-stakes troubles since last year. Among those was Detroit’s $18 billion bankruptcy in July 2013, a record size for a U.S. city. Investors have also fixated on Puerto Rico, which lost its investment grades this year as the commonwealth and its agencies grapple with $73 billion of debt.

Investors have speculated that the cash-strapped Puerto Rico Electric Power Authority would be the first public corporation in the U.S. territory to use the island’s new debt-restructuring law to reduce obligations. With $8.6 billion of debt, the agency would represent the largest restructuring ever in the state and local-debt market.

Municipal bond prices were little changed yesterday. Yields, which move in the opposite direction as price, on benchmark 10-year debt dropped to 2.20 percent yesterday, down 0.01 percentage point from Friday, according to Bloomberg indexes.

The Wall Street Journal reported earlier on the possibility that munis wouldn’t be included in the rule.

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