WASHINGTON - Bank regulators may think excluding municipal securities from high-quality liquid assets in their liquidity rule is no big deal, but Moody's Investors Service issued a report on Friday saying it may negatively affect credit ratings in the muni market.
"The first minimum liquidity coverage requirements for U.S. banks is a credit negative for the municipal bond market because municipal bonds would not qualify as high-quality liquid assets that banks must hold to cover potential liquidity draw downs," Moody's said. "The exclusion presents one less reason for banks to buy municipal bonds and will likely increase funding costs in the municipal market as a result."
The muni market shrunk this year while bank holdings of munis rose. Outstanding municipal debt during the first quarter of 2014 was $3.66 trillion, compared to $3.77 trillion as of December 2010. However, during that time, U.S. bank holdings of munis grew faster than any other investor category - increasing by $171 billion to $425 billion, according to the Federal Reserve Board's Flow of Funds data.
The liquidity rule was adopted by bank regulators on Sept. 3 to implement Basel III and ensure banks have enough assets that can be converted into cash or easily marketed during a period of financial stress. Bank regulators said they did not include munis as HQLAs because generally munis are not liquid and are not easily marketable.
But dealer groups and individual dealers fought against the exclusion, arguing investment-grade munis have lower default rates than corporate bonds and are easily marketable. They warned that the exclusion of munis would raise borrowing costs for issuers, as well as decrease liquidity and increase volatility in the municipal market.
At a recent Senate Banking Committee, Sen. Schumer made the same points, urging the bank regulators to include investment grade munis as HQLAs.
The regulators from the Federal Reserve Board, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, all told Schumer that they were open to the idea of adding munis as HQLA to the liquidity rule. But many market participants are skeptical they will change their minds, since they continue to say that banks don't hold munis for liquidity.
Moody's also said there is no guarantee that the liquidity rule will be changed.
"U.S. regulators have said they will continue to review municipal bonds to develop criteria under which some of them could be included as HQLAs, but at this time there is no indication of how these will be determined or when such revision will be implemented," the rating agency said. "In the meantime, [the] exclusion will put downward pressure on banks' purchase of municipal securities."
