A key piece of the Basel III banking reform is the Liquidity Coverage Ratio (LCR), which requires banks to hold a specified amount of High-Quality Liquid Assets, defined as securities that can be converted easily and immediately into cash. In the original proposal, all municipal bonds were excluded from the list of eligible securities. This had been perceived by many to be a market negative because banks have been a growing source of demand for municipal securities over the last few years, and a decision to exclude munis from the HQLA category could result in forced sales. Banks have nearly doubled their holdings of municipal bonds to over 12% of the total market according to a Wall Street Journal article on the subject (citing Federal Reserve data). A new Fed proposal allows munis to be counted as HQLA, but is very limited in scope, capping exposure to 5% of the total buffer required and subjecting the bonds to a 50% haircut when calculating the ratio. In addition, the proposed amendment would only allow certain general obligation bonds, while omitting large high-grade revenue bond issues. The Fed is not the only regulator with a say in the matter, either. The OCC and FDIC also have regulatory authority and have not committed to any proposed changes. Comments on the proposed rule are being accepted until July 24th of this year. We expect that the rule will not have a large effect on the market, especially given that when municipal bonds were not originally included as being HQLA, banks continued to expand their holdings.
Sources: WSJ, Bloomberg, FCM research, SNWAM Research