Study finds HQLA classification of munis lowered issuance cost
Classification of municipal general obligation bonds as high-quality liquid assets in 2015 to help banks meet their minimum liquidity coverage ratios lowered issuer costs and led to an increase of bank purchases of them.
That’s the findings of a study originating from the University of Minnesota that, for the first time, provides rigorous quantitative evidence supporting the widely held belief that the municipal bond market benefits from the classification.
Jacob Ott, a Ph.D. student in accounting at the university's Carlson School of Management, found the initial Federal Reserve policy shift in 2015 reduced the borrowing cost of GO bonds by about 5 basis points relative to the same issuer’s revenue bonds.
Ott emphasized during a webcast presentation last week at the Brookings Municipal Finance Conference that he focused solely on a change in a banking regulation and not on any change in municipal bond market regulations.
“I think five basis points, in terms of a non risk-based demand change, would be sort of in line with expectations,” Ott said. “If it was something much more than that, it would actually, for me, cause more concern.”
Ott also found the cost savings resulting from the regulatory change led municipalities to shift their issuance more toward GO bonds than revenue bonds.
The findings are significant, say experts who saw Ott’s webcast presentation last week at the Brookings Municipal Finance Conference.
“We, over the years, have certainly done back-of-the-envelope math to demonstrate the value from an advocacy standpoint, but nothing like this,” said Michael Decker of the Bond Dealers of America. “And certainly nothing like this existed when they were drafting the first HQLA rule.”
Emily Brock, director of the federal liaison center for the Government Finance Officers Association, said the study represents “great work building on a literature that tended to focus on banks.”
The study didn’t look at the subsequent action by bank regulators in 2019 to include revenue bonds. The 2019 rule change was required by Congress in the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.
“Five basis points is a lot, especially on an aggregate basis across the whole market,” Decker said. “Issuers work hard to try and save five basis points. If an issuer can save five basis points, they’ve done their job for the day.”
Brock agreed. “Five basis points savings to issuers is a very important finding,” she said. “We’d encourage Mr. Ott to extend the investigation to the potential for elevating munis to level 1 or the inclusion of revenue bonds in 2018.”
Municipal bonds are currently classified as level 2B HQLA.
Decker said there’s a strong case for classifying municipal bonds as level 2A HQLA, but noted it took an act of Congress to persuade the Federal Reserve to classify them as level 2B.
Level 2A is amiddle classification. Level 1 is the highest.
The classification of certain bank holdings as “high quality liquid assets” is an outgrowth of one of the key reforms that emerged from the 2007-2008 financial crisis.
In 2010 the international Basel Committee on Banking Supervision developed the liquidity coverage ratio as a survival tool for banks. The LCR, as it is known, is the amount of liquid assets a bank would need to survive for 30 calendar days in a crisis. That time frame, so the thinking went, would allow banking regulators such as the Federal Reserve enough time to step in and rescue the bank.
The international standards originally included municipal bonds as eligible to be part of the LCR, but the Federal Reserve initially excluded them.
In April 2015 the Wall Street Journal first reported that the Federal Reserve planned to reclassify certain municipal bonds as high quality liquid assets and, a month, later the Fed did so in regard to GO bonds but not for revenue bonds.
Ott’s study focused on a 60 days around that time period.
Ivan Ivanoff, a senior economist in the Division of Research and Statistics at the Federal Reserve, suggests the study could be expanded to find out if the issuer savings was concentrated among small, medium or large issuers.
Ivanoff, who formally critiqued Ott’s study for the Brookings conference, said it also would be valuable to know if the main beneficiary of the savings was the state, county or municipal government.