Municipal Bonds Excluded from HQLA; Not a Concern

On September 3rd the Federal Reserve, in concert with other regulators, announced the details of a new liquidity rule being implemented as part of the Basel III bank reforms.  In order to ensure liquidity and operational continuity in times of crisis, banks are being required to hold a certain amount of high quality liquid assets (HQLAs) that can be readily converted in private markets to cash to cover up to 30 days of liquidity needs.  The announcement last week details which securities will qualify as HQLAs and, as expected, municipal bonds have been excluded.  There have been some concerns expressed about the impact this might have on the municipal bond market, as banks were a growing source of demand for munis in recent years (though this has slowed in the last few months).  SNWAM’s view is that this decision will have a limited impact on the broad municipal market since most banks anticipated this rule and positioned their balance sheets under the assumption that they would not be able to count munis in the HQLA category.  In addition, banks only hold about 11% of outstanding municipal bonds and therefore are not a large player in the market.  While there is potential at the margin for this rule to mildly exacerbate volatility in a market sell-off, the current supply/demand imbalance and the lack of any effect from this rule on much larger groups of market participants (primarily individual investors) should prevent any significant consequences.  Finally, in a separate statement, Federal Reserve Governor Daniel Tarullo announced that select municipal securities may ultimately be included on the list of HQLAs at a later date.