A Liquidity Rule Dormant Since 2016 Is Getting a Second Life, and Banks Say the Treasury Market Can’t Handle It

As regulators move forward on finalizing net stable funding ratio, bank trade group says rule would have worsened March meltdown

Jerome Powell (left), the Federal Reserve chairman, with Fed Vice Chair for Supervision Randal Quarles in February 2018. The central bank and other regulators are working on finalizing a liquidity standard known as the net stable funding ratio, which was first proposed in 2016. (Alex Wong/Getty Images)
October 15, 2020 at 6:08 pm ET

Regulators are picking back up a long-delayed liquidity rule before a potential administration turnover after the presidential election, reviving concerns among banks that it could hobble the smooth functioning of markets — concerns that have taken on new urgency after the Treasury market meltdown in March. 

The net stable funding ratio is a liquidity benchmark proposed in 2016 by the Federal Reserve Board, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency. They took comments, but the rule has been delayed as regulators turned their focus to other priorities, such as tailoring bank regulation during the Trump administration and dealing with the economic fallout from the pandemic.

Many in the banking industry assumed the rule would stay on the back burner during the pandemic, but Randal Quarles, the Federal Reserve’s vice chair for supervision, said Sept. 29 at a livestreamed event on financial regulation hosted by Harvard Law School that the rule would be finished “quite soon.” And on Tuesday, the FDIC will vote on a final NSFR rule at its open meeting. 

The Bank Policy Institute, a trade group that has warned that the current NSFR proposal could limit lending and trading activity, has expressed alarm at the developments, arguing that the rule would have created an even greater seizure of the Treasury market this spring. At the time, the Fed had to deploy many tools in its 2008 playbook, including heavy purchases of securities, to soothe investors and get the Treasury market moving again. 

Had the NSFR been in place, Bill Nelson, chief economist at BPI, said the measure would have punished banks for holding Treasury securities and prevented them from helping the market when it seized up because of too many sellers and not enough buyers. 

“In March, the linchpin of the global financial system was on the brink of collapse,” Nelson said. “Had the NSFR been in place, institutions would have been even less able to purchase those securities, and the situation would have been worse.” 

The rule, designed in the wake of the 2008 financial crisis to make sure that financial firms have enough liquidity to meet its obligations over a one-year period, would assign different risks to different liabilities and assets depending on the stability of those liabilities and assets. 

For example, coins and banknotes would receive a zero percent rate stable funding factor, while things like nonperforming loans or fixed assets would receive a 100 percent rate stable funding factor. The ratio of the available amount of stable funding and required amount of stable funding should be equal to at least 100 percent on an ongoing basis, according to the proposal. 

The most stringent requirements would apply to banks with more than $250 billion in total consolidated assets. It’s one of two key liquidity ratios — the other being the Liquidity Coverage Ratio, a 30-day measure that U.S. banks already comply with — designed by the international Basel Committee on Banking Supervision. 

Nelson said the U.S. regulators’ version would have assigned unfair values to Treasury securities. So, when Treasury markets seized up in March, broker-dealers would have had even less incentive to purchase Treasurys because it would have lowered their NSFR and strained balance sheets further. 

For economic policy analysts like Gregg Gelzinis of the Center for American Progress — which had close ties with the Obama administration and has already released a list of financial policies that could be changed under a potential Joe Biden presidency — the turmoil in the Treasury market is proof that the system needs more regulation, not less. 

Forgoing the NSFR would allow banks in periods of stress to use reserves to buy Treasurys without a commensurate increase in financial stability safeguards, which would only increase frailties in banks, he contended. 

While the Fed’s intervention prevented that from happening this time, there’s no guarantee the Fed would step into the markets again as it continues to analyze the March Treasury market turmoil and considers how to handle the market and its vulnerabilities going forward, he said. 

“We did see a lot of turmoil and a lot of instability, and it’s a problem that needs to be solved,” Gelzinis said. “But you don’t solve it by shuffling around fragilities.” 

On NSFR, Gelzinis said that the Treasurys are weighted fairly in the way the bank regulators outlined the rule in 2016, despite industry complaints that Treasurys are a stable source of funding. “But that’s not right; they’re a highly flighty funding source,” he said.

In addition, regulators should consider safeguards on hedge fund leverage and other structural solutions, he said.    

The late-in-game momentum for NSFR is likely coming because regulators want to push through their version of the rule before a possible change in the administration, Nelson said, and they will want to finalize the NSFR before the Basel Committee’s virtual meeting Oct. 19-22 and in advance of the Group of 20’s Nov. 21-22 virtual summit. (The Federal Reserve declined to comment.)

Brett Waxman, senior vice president and senior associate general counsel at BPI, said that the trade group is “looking to be engaging in discussion” with policymakers on the issue now that it’s been picked back up by regulators. 

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