Fixed Income Strategies

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1 Basel III Liquidity- Lessons for Community Banks Ryan Henley, CFA For the past twelve months, we have immersed ourselves in an evaluation of the Basel 3 capital rule set, involving a considerable amount of exchange with examiner contacts for clarity regarding certain aspects of the rule. We have developed granular modeling capabilities for our clients, concerning all of the phase-ins for deductions/adjustments and balance sheet growth/retained earnings assumptions. And yet in the midst of this capital planning activity, another Basel rule was released. On September 3, 2014, the examiners issued their Basel 3 Liquidity rule set entitled Final Rule Liquidity Risk: Liquidity Risk Measurement Standards. With an eye towards foreshadowing, the reader should know now that community banks are explicitly exempt from the calculation. However, the rule will have far reaching implications for the markets in which community banks compete going forward into next year and beyond. Below, we would ask the reader to be patient as we explore several components of the rule itself: Who is subject to the rule? What are the required calculations? What instruments will contribute towards its satisfaction? This patience will be rewarded as we explore the lessons applicable to community banks: What investment instruments will exhibit greater demand due to larger bank needs? What are the deposit pricing implications? What lessons can be learned for liquidity stress testing exercises? (Note these Lessons are isolated to summarize certain concluding comments at break points in the article) Who is Subject to the Rule? Although the entire universe of banks are subject to the Basel 3 capital rule set (in various forms), Basel 3 Liquidity rules have a very different audience. The groups include: a. Institutions >= $250 Billion in Total Assets b. Institutions >= $10 Billion or more in Total Consolidated On Balance Sheet Foreign Exposure i. Consolidated Subsidiary of Either Two Listed Above With >= $10 Billion Assets These institutions have an effective date of January 1, 2015 with a phase in period leading into Additionally, a Modified calculation applies to the following banks: a. Institutions >= $50 Billion in Total Assets not captured in the previously mentioned categories These institutions will have an effective date of January 1, 2016 with a phase in period leading into Again, community banks are explicitly exempt from the rule s requirements. Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 1

2 The Liquidity Coverage Ratio (LCR) Calculation The LCR calculation is intended to capture in ratio form, the stock of high quality liquid assets (HQLA) to a net cash outflow value. In other words, these institutions will have to hold at least dollar for dollar (> ratio of 1) liquid assets relative to this net outflow result. The net outflow is calculated for the next 30 calendar day period. High Quality Liquid Assets (HQLA) Numerator The numerator of high quality liquid assets is built using a principles based approach. Assets must meet the following criteria in order to qualify: 1. Unencumbered assets 2. Flight to quality characteristics 3. Sale and repurchase markets with significant diversity in market participants 4. High trading volume 5. Central bank eligibility It is worth noting that this segregation of qualifying instruments is less credit driven, instead primarily focusing on liquidity and volume. Although one might immediately look towards explicit government guarantees or government agency securities that are explicitly backed by the full faith and credit of the United States government, there are several instances where this would likely be a difficult position to defend as HQLA. The entirety of HQLA is broken into three distinct buckets, Level 1, Level 2A, and Level 2B. The fair values of Level 1 instruments are unlimited in their contribution to HQLA. Level 2A instruments have a 15% haircut of fair value and Level 2B instruments carry a 50% haircut of fair value. The sum of Level 2A and 2B cannot exceed 40% of HQLA and Level 2B alone cannot exceed 15% of HQLA. Level 1 Instruments Reserve Bank Balances Foreign Withdrawable Reserves Security issued by, or unconditionally guaranteed as to the timely payment of principal and interest by, the U.S. Department of the Treasury Security issued by, or unconditionally guaranteed as to the timely payment of principal and interest by, a U.S. government agency (other than the U.S. Department of the Treasury) whose obligations are fully and explicitly guaranteed by the full faith and credit of the U.S. government, provided that the security is liquid and readily-marketable Issued by, guaranteed by, sovereign entity, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, European Community, or a multilateral development bank, that is zero risk weight, liquid and readily marketable, not an obligation of financial sector Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 2

3 Please note the carefully added phrase related to government agency securities above provided that the security is liquid and readily-marketable. This speaks to the necessity of the institution to prove that trading volumes are in fact high. This requirement is noticeably absent in all other asset classes referenced above. As mentioned earlier, this could disqualify certain relatively lower volume government agency explicitly guaranteed instruments from HQLA. Also note that the language clearly disallows municipal bonds from any form of HQLA. Under the final rule, securities issued by public sector entities, such as a state, local authority, or other government subdivision below the level of a sovereign (including U.S. states and municipalities) do not qualify as HQLA. [ ] To ensure adequately liquidity, the final rule only includes as HQLA securities that can be easily and immediately convertible into cash with little or no loss of value during a period of stress, either by sale of through a repurchase transaction. 1 Finally, Collateralized Mortgage Obligations are never addressed in the ruling (neither included nor excluded). The industry continues to debate this topic, but appears to feel somewhat confident in defending standard CMO structures (PAC1, SEQ, etc.) as liquid and readily-marketable. Level 2A Instruments Liquid and readily-marketable and is one of the following types of assets: o Security issued by, or guaranteed as to the timely payment of principal and interest by, a U.S. government-sponsored enterprise, that is investment grade under 12 CFR part 1 as of the calculation date, provided that the claim is senior to preferred stock; or o Security that is issued by, or guaranteed as to the timely payment of principal and interest by, a sovereign entity or multilateral development bank that is not eligible for Level 1, 20% risk weight and certain historical records of limited price volatility and repo haircut performance during stressed market conditions This category would include for instance FNMA and FHLMC passthroughs and potentially simple CMO structures. The argument becomes problematic when one looks towards multifamily instruments like DUS/Aces/Ks. These volumes are considerably lower relative to the FN/FH passthroughs discussed earlier and could prove difficult to defend as liquid and readily marketable. Level 2B Instruments Asset is liquid and readily-marketable and is one of the following types of assets o Investment grade corporate debt with certain historical records of limited price volatility and repo haircut performance during stressed market conditions, no financials o Publicly traded common equity share inside the Russell 1000 Index with certain historical records of limited price volatility and repo haircut performance during stressed market conditions, no financials Lesson #1 For community banks, the lesson here would be to understand where certain players in the market (those subject to the LCR rule) will naturally gravitate within their investment portfolio, thereby creating elevated demand for those products. 1 Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 3

4 As community banks are exempt from this rule (liquidity requirements similar but less strictly defined), this would likely provide relative value opportunity in certain investments that these larger institutions will necessarily ignore. Net Cash Outflow Calculation Denominator The denominator of the equation is composed of net cash outflows expected over the next 30 calendar days. The institution can utilize cash inflows up to 75% of the cash outflow over the period. The calculation has interesting implications when one looks to the runoff treatment required for various liabilities (non-maturity accounts as well as brokered and secured funding). The tables below illustrate these expectations. Bear in mind that each dollar of outflow requires a corresponding dollar of lower yielding, liquid assets, investments an institution would prefer to keep at a minimum. **Dependent on sweeping entity being affiliate and if total amount is covered by insurance *** To tailor the minimum quantitative standard for modified LCR holding companies while generally maintaining the amount of HQLA required for these firms under the proposal, the Board is amending the modified LCR denominator such that the net cash outflows shall be the net cash outflows calculated under the unmodified liquidity coverage ratio requirements over a 30 calendar-day stress period (excluding step 2 of the peak day approach described in section II.C.1 of this Supplementary Information section) multiplied by a factor of 0.7. One should take special note of the definition of the lowest runoff rate category above, Stable Retail Deposits (3%). This is defined as an account that is entirely covered by insurance. Therefore, if an account has $251,000 (which crosses the insurance threshold), the entirety of the account is thrown into the Other Retail Deposit category, not just the fractional amount in excess. Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 4

5 Lesson #2 Once again, institutions subject to the ruling will try to minimize this net cash flow amount by any means necessary in order to lessen the amount of liquid assets that must be held. This certainly creates an incentive for these institutions to focus on gathering as many Stable Retail Deposits as possible, as opposed to larger Other Retail Deposits. As community banks are not subject to this ruling, they could perhaps point their deposit gathering efforts towards these larger relationships which could prove to have less competition going forward. The grids below illustrate the runoff rates required for secured funding maturing within the next 30 days and the treatment of unfunded commitments: Lesson #3 *Not a comprehensive list We have written before regarding the treatment under Basel 3 capital rules on unfunded commitments that do not contain the language unconditionally cancelable. Although that ruling applies to all banks, the LCR rule above creates another incentive for larger institutions to insert this language into their commitment contracts. By inserting this language, the larger institution can avoid the runoff rates illustrated above. This again provides community banks a competitive advantage on these types of terms as they are not held to the same liquidity standard. Conclusion While capital rule changes have rightfully taken the majority of attention over the preceding months, the recent liquidity ruling merits consideration as well (despite its explicit exemption for community banks). The competitive landscape will undoubtedly be affected by this ruling over the coming years. Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 5

6 We would conclude with one final lesson. Although community banks are not subject to the recently issued LCR ruling, they are subject to the Interagency Policy Statement on Funding and Liquidity Risk Management issued in March The following excerpt illustrates the agencies requirements for community banks regarding holding a stock of liquid assets: Lesson #4 30. Management should ensure that unencumbered, highly liquid assets are readily available and are not pledged to payment systems or clearing houses. The quality of unencumbered liquid assets is important as it will ensure accessibility during the time of most need. An institution could use its holdings of high-quality securities, for example, U.S. Treasury securities, securities issued by U.S. government-sponsored agencies, excess reserves at the central bank or similar instruments, and enter into repurchase agreements in response to the most severe stress scenarios. 2 As one looks to define the appropriate amount of liquid assets mentioned within this excerpt, the runoff rates shown within the LCR ruling earlier could prove as a backstop to those actually used within the institution s own liquidity stress testing efforts. However, we would encourage institutions to build their own runoff assumption set from the bank s unique history as it is both specific/defendable for the institution in question and likely results in a much milder stressed scenario (requiring less liquid assets).. Ryan Henley, CFA Senior Managing Director, Head of Financial Institutions Strategy rhenley@sterneagee.com 2 Sterne, Agee & Leach Inc. is Member NYSE, FINRA, SIPC 6