Bank Liquidity Requirements Could Reduce Muni Demand

As a follow-up to our note on strengthening bank credit quality arising from stricter capital and liquidity requirements, we see another potential ramification in the municipal market once these rule changes are implemented in 2015.  Over the past few years, U.S. banks have increased their municipal debt exposure.  Bloomberg recently reported that JP Morgan doubled its holdings of municipal debt between June 2012 and June 2013, while banks’ municipal holdings as a whole have grown to 10.5% of the total market from 6% three years ago.  This demand helped support the municipal market, as retail investor appetite weakened and municipal mutual funds saw record outflows. Under the newly proposed liquidity requirements, securities issued by public sector entities, such as states and local authorities, would not qualify as high quality liquid assets.  The Federal Reserve believes the credit quality of these assets is high but, at this time, they do not exhibit the appropriate liquidity profile.  The Federal Reserve uses an average daily trading volume as a measure of liquidity.  An alternative measure that might be more useful is the bid-ask spread.  Nonetheless, if the banking sector were prohibited from applying municipal debt to its computed liquidity coverage ratio, then we could see a further slackening of demand for munis in the years ahead and even lower trading volumes with wider bid-ask spreads.  This less liquid, more volatile environment will likely provide an excellent relative value buying opportunity during market sell-offs as the fiscal conditions improve the credit quality of well-managed issuers.