Liquidity Rule More Likely to Drive Up Costs of State and Local Investments

cohen-natalie-credit-bloomberg-357.jpg

WASHINGTON - The bank liquidity rule is more likely to drive up the costs of investments than infrastructure development for state and local government investments, according to a Wells Fargo Securities research report.

Sen. Chuck Schumer, D-N.Y., and some muni market participants have warned that the rule, which is designed to ensure banks have enough assets that can be converted to cash or are easily marketable during periods of fiscal stress, could impede infrastructure development.

The rule, which is slated to start taking effect next year, will require large banks to maintain a liquidity coverage ratio of high-quality liquid assets to total net cash outflows. But bank regulators do not include munis as HQLAs, saying they are not liquid enough.

Schumer and market participants are urging the bank regulators to modify the rule to define investment-grade munis as HQLAs, warning that otherwise borrowing costs will increase for state and local governments and the muni market will become less liquid and more volatile.

Natalie Cohen, a Wells Fargo Securities senior analyst, noted in the research report that the liquidity rule's strictest application of its liquidity coverage ratio applies only to those banks with more than $250 billion of assets - 13 financial institutions. Lighter restrictions are in place for banks with assets between $50 billion and $250 billion - an additional 23 institutions, she said. So the rule's greatest impacts would be on only 36 of the 6,500 insured banks in the U.S.

"When you total up just the municipal securities holdings of the $50 billion-and-up banks, you come with about $155 billion for the first quarter, she said, referring to an American Bankers Association publication. "That is not enough to move the pricing dial, in our opinion, in the $3.6 trillion municipal market - particularly when you take into account that banks categorize a portion of their municipal securities as 'hold to maturity.'"

While infrastructure is at its lowest level in nearly 15 years, the new liquidity rule has not even taken effect yet. Interest rates are at very low levels, but so is state and local borrowing.

Cohen said state and local governments are not borrowing for three major reasons. First, rising pension and health care costs are increasingly taking a bigger bite out of their budgets. Second, economic recovery, while felt in some places, has not been across the board.

"It is a tough sell to ask voters for higher revenues to cover legacy costs and pay for new debt," Cohen said. "This is particularly true in places where tax reductions are being sought."

Finally, Congress has been unable to pass long-term legislation for transportation, "weakening the market's confidence," Cohen said. State and local officials have complained they simply can't proceed with projects, given the uncertainty about what kind of funding they will have in the future.

The bigger impact from the liquidity rule is likely to be on state and local government investments, she said. More than 90,000 governments in the U. S. are faced with having to temporarily deposit their cash somewhere, Cohen said. Demand deposits from state and local governments as reported on the 13 largest bank call reports were $45.7 billion in the second quarter of this year, she said. Non-demand deposits came to an additional $121.3 billion for the same period. Those figures total $167 billion -- more than the $155 billion of municipal securities held by banks with more than $50 billion of assets, she said.

"While the agencies softened the final rule, so that municipal deposits would be stressed assuming a milder "run" on the bank, not being able to use municipal securities as collateral could ultimately lead to higher costs for these many depositing municipalities," Cohen warned.

As an alternative, governments could invest their cash in local government investment pools, but LGIPs are supposed to be governed like money market funds under Governmental Accounting Standards Board standards and the Securities and Exchange Commission just approved rules requiring MMFs to have floating net asset values.

Still, Cohen says the bank regulators should include some munis as HQLAs. She questioned why they included sovereign securities as HQLAs, when sovereigns like Greece and Slovenia have had financial disasters. Triple-A rated munis, in comparison, are much safer, she said.

The Volcker Rule, and its failure to exempt tender option bonds, will also impact the muni market next year, Cohen said.

The $70 to $80 billion TOB market historically has been used to provide short-term, tax-exempt munis to money market funds. In a typical TOB program, the sponsor will deposit a fixed-rate bond or note into a trust, which will issue two new certificates - a floating rate certificate and a residual certificate. The floating rate certificate will have a tender option through a liquidity facility that is typically issued by the program's sponsor or an affiliate and shortens the maturity of the bond or note so it becomes eligible to be purchased by a tax-exempt money market fund.

"Market participants are currently looking at a variety of new structures that would be compliant with the rule, as money market funds commonly use this product," Cohen said, adding, "No solutions have merged yet, at this writing, which have passed muster."

If banks that sponsor TOB programs are not able to comply with the Volcker Rule by July 21, 2015, "we expect to see an unwinding of trusts resulting in a sale of trust assets along with draws on liquidity facilities supporting such trusts," she said. However, investors interested in long-term paper, such as pension funds and insurance companies, could jump in and buy the expected $65 billion of long-dated bonds that could appear on the market, she added.

Cohen said that while Wells Fargo Securities does not expect market disruption from these rules, "we do expect the cost of doing business for state and local governments to increase - not so good for the future of infrastructure and a bit more sand in the gears of economic recovery."

For reprint and licensing requests for this article, click here.
Law and regulation
MORE FROM BOND BUYER