Congress appears poised to pass financial regulation reform legislation (S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act) that would, among other changes, require federal bank regulators to treat many investment-grade municipal securities as “High Quality Liquid Assets” (HQLA) for the purpose of the agencies’ Liquidity Coverage Ratio (LCR) rules. Congress’ action will come more than three years after the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. finalized three nearly identical rules that excluded municipal securities from the HQLA definition. It comes more than two years after the Federal Reserve, acting alone, approved largely ineffective amendments to its LCR rule designed to permit a subset of municipal securities to count as HQLA, ineffective in part because the Fed excluded revenue bonds from HQLA treatment.
Why did the agencies exclude municipal securities from their HQLA definitions? Why will it have taken an act of Congress to budge the agencies on this issue? The LCR regulations are not the first time federal bank regulators have written rules governing bank investment in the municipal market suggesting a lack of recognition of the performance of infrastructure-related debt like municipal securities. Regulators imposed new bank capital rules imposed in 2013. For bonds held for investment by banks using the standardized approach for calculating capital, the rules distinguish between general obligation bonds in the 20% risk weighting category and revenue bonds in the 50% category despite nearly identical credit performance. The reason they gave at the time? “The agencies believe that such dependence on project revenue presents more credit risk relative to a general repayment obligation of a state or political subdivision of a sovereign.”
Recent research at the World Bank, however, suggests regulators on a global basis are overestimating the risks associated with investment in infrastructure-related debt. In a paper published recently titled “Credit Risk Dynamics of Infrastructure Investment: Considerations for Financial Regulators,” World Bank researcher Andreas Jobst looks at new data related to the performance of infrastructure-related debt, especially “project finance” debt, the rough equivalent of our revenue bonds.
“The risk characteristics of project finance, which is a crucial source of funding infrastructure, have yet to be reflected comprehensively and consistently in most solvency regimes,” Jobst states in his piece.
Jobst analyzed data provided by Moody’s Investors Service on the performance of infrastructure-related loans and debt securities. The analysis finds, as we know well from our experience in the municipal bond market, that default rates for infrastructure debt are low and decline over time and that recovery rates in bankruptcy are high.
Although Jobst applies his analysis principally to insurance company regulation, similar conclusions can be drawn for banks. Applying his findings related to the credit performance of infrastructure debt to insurance company capital requirements, Jobst concludes “The declining downgrade risk of infrastructure debt—together with a high recovery rate (comparable to that of senior secured corporate loans)—would significantly reduce capital charges if standardized approaches [to determining capital requirements] recognized infrastructure as a separate asset class.”
The World Bank researcher also recognizes that rightsizing the regulatory treatment of infrastructure debt can offer broader economic benefits, including more institutional capital being directed towards infrastructure investment. “By increasing the rate of return of holding infrastructure-linked instruments, a differentiated regulatory treatment may help insurers (and other institutional investors) rebalance their asset portfolios over time towards infrastructure projects,” Jobst concludes.
The issue of HQLA status for municipal securities will not be fully settled when the president signs S. 2155. The job then will turn to the three federal banking agencies to rewrite their rules to comport with the new legislation. As the agencies begin that process, we will continue to urge them to study and consider carefully the credit and liquidity performance of municipal securities as infrastructure-related debt. When they do, they’ll find that municipals, including revenue bonds, deserve regulatory treatment consistent with their strong historic performance.