The case for liquidity regulation is strong. Failures of banks and broker-dealers are generally associated as frequently with a liquidity shortage (a run) as with insolvency. Of course, this phenomenon was fully evident in the global financial crisis, where overreliance on short-term wholesale funding became fatal at the firm level, but also created systemic risk as liquidity-starved firms engaged in fire sales and thereby drove down asset prices across the financial system.
Liquidity regulation also has significant costs. By reducing maturity transformation, it effectively prevents banks and other financial firms from serving their core function, and a function with considerable benefits for economic growth.
Several large banks have stated that it is the living will guidance, and not the LCR or other liquidity requirements, that currently is the binding determinant of the amount of liquidity transformation they produce. This guidance, which was issued in April 2016, imposes liquidity requirements by demanding that each of the largest banks operating in the U.S. determine its Resolution Liquidity Adequacy and Positioning, or RLAP, as well as its Resolution Liquidity Execution Need, or RLEN.
- RLAP requires the firm to estimate standalone liquidity needs for each material subsidiary over a minimum of 30 days of stress, and ensure sufficient liquidity is either pre-positioned in the subsidiary or otherwise available at the parent as HQLA to meet deficits. The parent must hold sufficient HQLA to cover the sum of all net liquidity deficits at every material subsidiary. Furthermore, firms are directed to assume that individual material subsidiaries will hoard the group’s liquidity resources. For example, firms are directed to assume overnight loans between subsidiaries will not be renewed and that a liquidity surplus at one material subsidiary cannot be moved to meet deficits at another subsidiary, or even to augment parent liquidity resources.
- RLEN requires the firm to further account for the estimated liquidity needed post-bankruptcy filing to support the surviving or wind-down subsidiaries, which can lead to a requirement for even more liquid assets at the subsidiary level.
The size of the liquidity requirements imposed by RLAP and RLEN are treated by the agencies as confidential supervisory information and thereby kept secret. To the extent that they are a binding constraint, however, they appear clearly excessive for a couple of reasons.
First, they don’t appear to fully account for SPOE, and the ability of recapitalized subsidiaries to access traditional funding sources, including market funding and, if needed, bank access to the discount window. The living wills of the largest U.S. banks all provide for a single-point-of-entry resolution whereby all material subsidiaries are recapitalized and continue in operation. Their ownership is transferred to a new bridge holding company that has been recapitalized through a bail-in of the old holding company’s unsecured, long-term bondholders. The Federal Reserve’s TLAC requirement requires these firms to hold sufficient (and massive) loss absorbency at the holding company level to allow this recapitalization, and the ISDA protocol prohibits derivatives creditors of a material (or any other) subsidiary from treating a holding company insolvency as an event of default and closing out the positions, a la Lehman Brothers.
All of this means that the firm emerging on Monday morning after undergoing a SPOE recapitalization will be well-capitalized and free from any destabilizing liquidity drains that might have been caused by counterparties closing out positions. Accordingly, the firm should be well-positioned to obtain any needed funding in the private market. Moreover, the firm’s bank subsidiaries, being well-capitalized, would be expected under Regulation A to have normal — that is, unrestricted — access to the discount window as a backup funding source, providing further confidence to market counterparties.
But don’t take our word for it. The FDIC agrees. In describing its plan for a SPOE resolution under Title II Orderly Liquidation Authority, the FDIC states about post-resolution bridge companies:
The bridge financial company would have a strong balance sheet with assets significantly greater than liabilities since unsecured debt obligations would be left as claims in the receivership while all assets will be transferred. As a result, the FDIC expects the bridge financial company and its subsidiaries to be in a position to borrow from customary sources in the private markets in order to meet liquidity needs…[emphasis added]
If the customary sources of funding are not immediately available, the FDIC might provide guarantees or temporary secured advances from the OLF to the bridge financial company soon after its formation. Once the customary sources of funding are reestablished and private market funding can be accessed, OLF monies would be repaid. The FDIC expects that OLF monies would only be used for a brief transitional period, in limited amounts with the specific objective of discontinuing their use as soon as possible.
In the FDIC’s Title II plan, the OLF plays the same role as the discount window – a temporary backup funding source that would be well-collateralized and promptly repaid.
We are not saying that firms in their Title I living will plans should be able to plan that their recapitalized bank subsidiaries would be able to meet their liquidity needs by borrowing from the discount window. Rather, the subsidiaries would be able to meet their liquidity needs like any other bank – by borrowing in the interbank market. It would only be if that source of funding were unavailable for some reason that it would plan on borrowing from the discount window.
Such a plan is completely consistent with the Fed’s stated role for the discount window. The Fed’s FAQs about the discount window state (referring to SR letter 03-15):
The Interagency Advisory on the Use of the Federal Reserve’s Primary Credit Program in Effective Liquidity Management (July 23, 2003) encourages depository institutions to consider the discount window as part of their backup liquidity arrangements. As is true of any backup liquidity facility, being prepared to borrow primary credit enhances an institution’s liquidity. The Advisory states that “bank supervisors and examiners should view the occasional use of primary credit as appropriate and unexceptional.”
Second, they require firms to maintain sufficient liquidity to meet the needs of each material surviving entity individually, rather than collectively. However, because all large firms adopt the SPOE strategy in their living will, there will always only be a single holding company owner of the firm’s subsidiaries after resolution. Under those circumstances, that holding company should be able to maintain a common pool of liquidity for all the subsidiaries, substantially reducing the overall need.
Given the excessive (and binding) nature of the RLAP and RLEN liquidity requirements, we think the living will guidance could benefit from being issued for public notice and comment. This would afford a transparent process through which to address key questions, like:
- On what standard are RLAP and RLEN requirements set for each firm?
- In assessing liquidity needs, is it presumed that an SPOE resolution takes place as set forth in an approved living will?
- Is the ISDA protocol considered in deciding liquidity needs for subsidiaries with derivatives exposures?
- What is the assumption about bank access to the discount window?
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.