Our Take: financial services regulatory update – August 23, 2024

• What happened? On August 13th, the Fed updated its FAQs on Regulation YY, or Enhanced Prudential Standards, which in part requires large banks to maintain buffers consisting of highly liquid assets (HLA) so they remain able to meet their financial obligations in times of stress. Separately, on August 19th, the Federal Housing Finance Agency (FHFA) published a report on its supervision of the Federal Home Loan Banks (FHLB) in light of lessons learned from the spring 2023 bank failures.
• What does the new FAQ say? The FAQ clarifies that banks may assume the use of non-private market sources, such as the Fed's discount window, standing repurchase facility (SRF), or FHLB advances, along with private market options to convert HLA into cash in their internal liquidity stress testing (ILST), including for the 30-day planning horizon. However, the FAQ also includes several qualifications:
  • Banks should not solely rely on non-private market sources and should sufficiently support their assumptions
  • Banks need to be able to demonstrate their capability to convert a “representative portion” of their HLA through actual, rather than assumed, sales or repo transactions in private markets
  • The FAQ should not be viewed as an expansion of the types of assets that qualify as HLA
  • Banks still cannot include lines of credit, including borrowings from the discount window or FHLB, as a cash flow source that reduces the amount of their net stressed cash-flow need over the 30-day ILST horizon
• What does the FHFA report say? Following the spring 2023 bank failures, FHFA examiners issued adverse examination findings and some informal enforcement actions on issues identified including weaknesses in the FHLBs’ lending philosophies, such as over-relying on collateral and not giving adequate attention to members’ creditworthiness. It also covers issues with terms for advances and limits in credit policies, bank credit risk assessments and ratings, and credit risk modeling.
• What’s next? The FHFA plans to issue supplemental guidance on FHLB supervision by September 30th, 2024. The banking agencies are considering changes to existing liquidity requirements including ones that would impact internal liquidity stress testing and HLA buffers, but may hesitate to issue any proposals before further action is taken on Basel III endgame.

Our Take

A meaningful change in liquidity stress testing assumptions. The FAQ revision is a notable departure from how banks have commonly implemented regulatory requirements for calibrating HLA buffer amounts to withstand a 30-day stress horizon. Frameworks for liquidity stress testing typically dictate that HLA must be sold or used as collateral in repo transactions with private market sources as banks are simulating scenarios in which non-private sources such as the discount window and FHLBs are not available for the first 30 days. Assuming that HLA can be monetized through non-private sources increases capacity to borrow against collateral, which is particularly valuable for banks that (a) have high amounts of unrealized losses (since the bank will not have to assume as many asset sales that result in losses); (b) have constraints or operational limitations on repo; or (c) have large held-to-maturity investment portfolios that constrain the private market repo capacity assumed in stress tests.

The agencies continue to encourage banks to use the discount window in times of stress. Beyond a previous addendum to their liquidity guidance and various remarks from agency leaders, the FAQ’s clarification more directly links usage of HLA in discount window and FHLB borrowing to liquidity risk management requirements. The clarification will prompt banks to assess how they should incorporate an expanded set of non-private monetization options into their ILST scenarios, but it will require them to make a number of determinations in order to do so. For example, they will need to determine what percentage of their HLA they can assume to be monetized through non-private sources but will be careful to avoid being criticized for an overreliance on sources like the discount window and FHLBs.

The FAQ also highlights some unchanged expectations that continue to present issues for banks. This includes the expectation to test their ability to monetize a “representative portion” of their HLA in actual sales or repo transactions, which is not new but has been an area where banks have experienced challenges and heightened scrutiny. Banks will also need to consider their strategy for pledging and monitoring HLA as operational frictions can make it difficult to move between the various borrowing options in stress.

In contrast, the FHFA report may influence FHLBs to become more cautious in lending to banks experiencing stress, which means banks need to consider scenarios where FHLB borrowing becomes constrained or unviable particularly during periods of sustained stress. While banks may shift stress testing methodologies to assume use of FHLB borrowing using HLA in the 30-day horizon, they would be wise to also consider the FHFA actions in analyzing potential loss of FHLB funding over longer-term stress horizons.