On October 24, 2013, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation proposed rules¹ implementing the Basel III liquidity coverage ratio (LCR). The proposed LCR is more stringent than the international LCR standard agreed to by the Basel Committee on Bank Supervision earlier this year,² and would apply to (1) bank holding companies (BHCs) with $250 billion or more in total assets or more than $10 billion in foreign exposure; or (2) non-insurer systemically important financial institutions and, in each case, to their consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets (collectively, covered companies). A modified version of the LCR would apply to BHCs with more than $10 billion in total assets. The proposed LCR would require a covered company to maintain an amount of high quality liquid assets (HQLA) at least equal to its total stressed net cash outflows occurring over a prospective 30-day period. Comments on the proposed LCR must be received by January 31, 2014.

The proposed LCR would affect end-users in several ways, including the following:

1. Definition of HQLA

A covered company may decide to apply a liquidity charge when accepting as collateral securities that do not qualify, or qualify only partially, as HQLA.

1. Securities Having No HQLA Value. The proposed LCR’s definition of HQLA incentivizes covered companies to require derivatives collateral in the form of U.S. Treasuries (USTs) and Ginnie Maes – “Level  1” HQLA which have 100% HQLA value -- and excludes from the definition of HQLA:³

• Securities issued by insurers, banks, swap dealers (as defined in the Commodity Exchange  Act or Securities Exchange Act), and any other company included within the proposed LCR’s definition of “regulated financial company” (RFC) and
• All ABS and non-Agency RMBS and CMBS.

2. Securities Having Partial HQLA Value. Level 2 HQLA may comprise no more than 40% of a covered company’s HQLA, and the proposed LCR would apply significant haircuts to these assets as follows:

• A 15% haircut to “Level 2A” HQLA, which include (1) qualifying “investment grade”⁴ obligations issued or guaranteed by U.S. government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, the Banks of the Farm Credit System, and the Federal Home Loan Bank (FHLB) system (excluding preferred stock of any such GSE), and (2) certain qualifying obligations issued or guaranteed by 20%-risk weighted sovereigns;⁵ and
• A 50% haircut to “Level 2B” HQLA, i.e., qualifying investment grade corporate debt and qualifying S&P 500/other qualifying equity securities, except for, in each case, securities issued by RFCs.⁶ Level 2B HQLA may not comprise more than 15% of a covered company’s HQLA.

2. Derivatives Collateral

The assumptions made in the proposed LCR regarding a covered company’s net derivatives cash outflow may affect the pricing of derivatives transactions where the counterparty has the right to post collateral other than cash, USTs, Ginnie Maes or other Level 1 HQLA. A covered company's net derivatives cash outflow would equal the sum of the payments and collateral that a covered company will make or deliver to each counterparty, less, if subject to a qualifying master netting agreement, the sum of payments and collateral due from each counterparty.

• Potential Liquidity Charge for Price Risk. For purposes of stressing collateral posted by a covered company, the proposed LCR would apply a 20% outflow rate to the fair value of any assets posted that are not USTs, Ginnie Maes or other Level 1 HQLA.⁷ As a result, covered companies may decide to include this outflow in a liquidity valuation adjustment to the price of a derivative transaction with an OTC derivatives counterparty that has the right to post non-Level 1 HQLA.
• Potential Liquidity Charge for Option to Post Non-Level 1 HQLA Collateral. The proposed LCR incentivizes a covered company to charge OTC derivatives counterparties for the option to post collateral other than Level 1 HQLA.⁸ If, for example, a counterparty has currently posted collateral comprising Level 1 HQLA, but retains the contractual right to post Level 2 HQLA, the proposed LCR would impose an assumed outflow rate of 15% (in the case of an option to post Level 2A HQLA), or 50% (in the case of an option to post Level 2B HQLA). As a result, a covered company may decide to charge a counterparty for the assumed outflow, unless the counterparty agrees to remove from its Credit Support Annex or other margin agreement the option to post non-Level 1 HQLA such as qualifying obligations issued or guaranteed by Fannie Mae, Freddie Mac or any FHLB.

3. Credit and Liquidity Facilities

For purposes of projecting draws during the 30-day LCR window, commitments to any RFCs, including insurers and financial market utilities such as the Chicago Mercantile Exchange, Inc. and ICE Clear Credit LLC, would be subject to a 40% outflow rate for credit facilities and a 100% outflow rate for liquidity facilities.⁹ As a result, the proposed LCR incentivizes a covered company to reflect these outflows in its pricing of undrawn commitments to such RFCs (unless such RFCs collateralize such facilities with Level 1 HQLA).