Our Take: financial services regulatory update – September 27, 2024

• What happened? On September 26th, Fed Vice Chair for Supervision (VCS) Michael Barr spoke on the Fed’s past and anticipated actions on liquidity requirements.
• What did Barr say? He provided background on the dynamics underlying the March 2023 bank stress as well as steps the Fed has taken and plans to take to address those dynamics:
  • Clarification on liquidity stress testing assumptions. Barr highlighted the Fed’s August update to 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. The update 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. He explained that this clarification should reduce constraints around monetizing HLA in stress, which in turn should allow banks to “reduce their demand for reserves in favor of Treasury securities, all else being equal, for their stress planning purposes.” He further said that increased substitutability between these assets and flexibility in adjusting portfolios should improve money market functioning.
  • New liquidity requirements. As he first previewed in May, Barr confirmed that the Fed is considering new liquidity requirements, including for banks to “maintain a minimum amount of readily available liquidity with a pool of reserves and pre-positioned collateral at the discount window, based on a fraction of their uninsured deposits.” He included two new clarifications: (1) community banks would be exempt from this requirement and it would be applied on a tiered basis; and (2) the collateral pre-positioned at the window could include both Treasury securities and the full range of assets eligible for pledging at the discount window.
  • Changes to existing liquidity requirements. Barr also confirmed that changes to existing requirements are being considered. One potential change would partially limit the extent of bank reliance on held to maturity (HTM) assets under large banks' liquidity coverage ratios (LCRs) and internal stress tests. Barr also reiterated that the Fed is reviewing the calibration of deposit outflow assumptions for certain types of deposits to better reflect observed behavior in recent stress periods. He also said the Fed is revisiting the “scope of application” of its liquidity framework for large banks.
  • The discount window. Barr noted that changes to liquidity regulations have aspects geared towards encouraging banks to be ready and willing to use the Fed’s discount window. In addition, he commented on the Fed’s efforts to improve discount window functionality, including a new online portal to request and prepay discount window loans and a request for information on discount window operations.
• What’s next? Barr did not say when new liquidity comments would be formally proposed, but Fed Chair Jerome Powell previously indicated that they would wait until after Basel III endgame is re-proposed. Comments on the Fed’s request for information on discount window operations are due by December 9th, 2024.

Our Take

New liquidity requirements are still in the works. Barr’s latest comments confirm that the new requirements he outlined in May, including a new coverage ratio based on uninsured deposit levels, are still on the Fed’s agenda. He also provided some additional insight into questions raised by his May speech by clarifying that the requirements would not apply to community banks and would follow a tiered approach. This still leaves the door open for an applicability threshold of $100 billion in assets in line with the long-term debt proposal as well as less stringent standards for “midsized” banks under $100 billion but larger than community banks. His repeated comment on revisiting the application of the current liquidity framework for large banks also suggests that the proposal could expand existing liquidity requirements such as the LCR to a larger population of banks by reversing some of the tailoring instituted in 2019. Although the Fed seems to have planned to propose new liquidity requirements after the Basel III endgame re-proposal, that timeline may need to be adjusted if the re-proposal is significantly delayed.

In the meantime, banks should be incorporating the Fed’s update to liquidity stress testing monetization assumptions. Although the Fed’s August update to its Reg YY FAQs was released without much media fanfare, banks have been actively attempting to interpret how to incorporate it into their liquidity stress testing frameworks. Its inclusion in Barr’s speech serves as a useful amplifier and explains the Fed’s reasoning on how the change could support market functioning by creating increased monetization capacity for Treasuries in order to produce same-day liquidity. The speech also connects the FAQ update to the potential new liquidity requirements in having a common goal for banks to “self-insure” against liquidity risks, including severe deposit withdrawals. 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. Both the anticipated new requirements and the updated FAQ also more directly connect discount window usage to liquidity risk management requirements. Banks should continue to assess how they can incorporate an expanded set of non-private monetization options, including the discount window, into their internal liquidity stress testing and contingency funding plans. As they do so, they should consider aspects of the discount window functionality that could be improved and provide that feedback to the Fed as it considers potential enhancements.