Why the new Reg YY FAQ may increase some US regional banks' exposure to interest rate risk
And regulatory "clarifications" on crucial topics like liquidity (and capital) should be subject to economic impact analysis and notice and comment periods; not be FAQs!
The global macro picture has been so interesting that M-FAB has not commented on a US banking topic in a bit. However, in the last two weeks I have had several people message to ask my thoughts on the Federal Reserve’s update to its Frequently Asked Questions (FAQ) on Reg YY (Liquidity Risk) that was released August 13. You asked; here we go!
Before turning to the new Reg YY FAQ, a bit of background is helpful. As part of Reg YY, Category I-Category IV bank holding companies (BHCs with assets > $100 billion) conduct internal liquidity stress tests (ILSTs) which are shared with bank supervisors at least monthly. These ILSTs span several horizons: overnight, 30-day, 90-day, and one-year. Banks need to hold highly liquid assets (HLAs), such as reserves at the Fed, Treasuries or agency MBS sufficient to meet estimated stressed net cash outflows. Banks also need to show supervisors that they can convert these HLAs to cash. US banks’ ILST assumptions and results are not publicly disclosed.
The new Reg YY FAQ stated that a bank can point to the official sector — its borrowing capacity against its HLA at the Fed’s discount window, the Fed’s standing repo facility or a Federal Home Loan Bank (FHLB) advance — as the means by which it plans to monetize its HLAs for purposes of liquidity stress testing.
The new FAQ does also state that:
1) banks shouldn’t rely solely on official sources (discount window/FHLB) to convert their liquidity buffers to cash and
2) the definition of HLA still does not include contingent borrowings from the discount window or FHLBs.
Both of these clarifications are important — but, if banks shouldn’t rely “solely” on contingent official sources to liquefy their HLA — precisely how much is it ok for them to rely?
Is 2/3rd reliance, ok?
80%, ok?
90%, ok?
There will be no public disclosure about how much reliance individual banks’ supervisory teams permit. My argument is that assumed official sector reliance in ILSTs for monetization should be low, but permitted reliance in real life higher. Why? Because if a bank can’t easily liquefy its HLA in private markets, it is highly plausible that may be because the HLA is trading at a significant discount to par or isn’t even really HLA. Risk does not divided neatly up into little buckets and interest rate risk (IRR) is highly intertwined with a bank’s liquidity risk and economic/market-based solvency.
In the normal course of balance sheet management, banks are exposed to IRR. Interest rate risk in the banking book (IRR-BB) is associated with banks’ holdings of loans and securities – bank assets – funded with deposits and other liabilities which also often have a shorter maturity profile than a bank’s assets. Maturity transformation is foundational to all banking. Indeed, it is key to how banks contribute to economic growth. But, the very maturity transformation which allows banks to make valuable contributions to economic growth, also can make banks vulnerable if IRR-BB is not well measured, managed and controlled. Excessive maturity transformation creates liquidity and economic/market-based solvency risks at a bank. Despite the spring 2023 bank failures, the US still has no quantitative limits on IRR-BB in regulation.
So regulators have indicated that a bank can use official sources to borrow its way out of an HLA that for some reason isn’t readily liquid (most likely due to interest rate risk). Worryingly, a bank’s significant reliance on the official sector to convert HLA to cash may merely serve to delay the recognition of excessive interest rate risk being transformed into liquidity and solvency risk for a bank.
Let’s agree that:
while it is true that low-credit risk option-free bonds, like Treasuries, pull-to-par by maturity, banks are levered fixed income investors — stated differently, their asset holdings are financed with borrowed money and the market value is not irrelevant; [note that my students seemed to get this last week when we discussed what is right and wrong about pull-to-par/rolldown and SVB in class!]
therefore, banks ignore the risks associated with HLA that trades at steep discounts at their peril — as these securities’ primary purpose is to allow them to meet their obligations timely without damaging capital;
secured borrowing from official sources, like the discount window or FHLBs, does allow banks to liquefy HLA that may be trading at a discount without realizing an immediate loss on the asset;
however, incurring new liabilities at higher interest rates when your HLA already is substantially below par, both negatively impacts profitability and increases a bank’s economic capital shortfall/market implied default risk which can erode market confidence and the bank’s funding profile;