US banks anticipate fresh guidance on resolution liquidity

Consultation in first half of 2020 expected to clarify intra-group and forecasting requirements

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Giving directions: market participants say RLAP and RLEN guidance is perhaps the easiest to tweak

US prudential agencies are likely to prioritise resolution-planning liquidity guidance in a review of existing requirements, which is considered urgent following last September’s repo market volatility, has learned.

Federal Reserve chairman Jerome Powell told a press conference on January 29 that regulators were “well along” with this review of liquidity rules.

Although bankers tend to finger other items as the main contributors to tight market conditions, market participants say guidance on resolution liquidity adequacy and positioning (RLAP) and execution needs (RLEN) is perhaps the easiest to tweak.

Unlike the Basel Committee’s liquidity coverage ratio (LCR), RLAP and RLEN are US-specific rather than the product of internationally agreed standards. And since the agencies would be changing guidance rather than rules, the initiative would not be covered by the Administrative Procedure Act (APA), giving the regulators more flexibility on how they conduct their review.

“You’re seeing potential unintended side-effects of the high liquidity requirements for banks, certainly through the LCR and also through the RLAP process of having to have liquidity in material entities,” says Keith Noreika, a partner at Simpson Thacher & Bartlett, who was acting head of the Office of the Comptroller of the Currency in 2017. “I think the governors are well aware of it, and it is something we’re going to see them looking at in the spring.” 

Guidance on RLEN and RLAP is intended to help banks fulfil Dodd-Frank Act requirements for resolution planning, which were originally issued in 2014 and partly revised in 2019.

The piece that the industry is waiting on
Mark House, Chain Bridge Partners
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Keith Noreika

Under a final rule, published in November 2019, which took effect at the start of 2020, the eight US-headquartered global systemically important banks (G-Sibs) must file full resolution plans every two years, with a smaller targeted plan in each intervening year.

The first filing under the new rules will be a targeted plan in July 2021, with the first full plan following a year later. The November 2019 rule says the agencies will “strive to provide final general guidance at least a year before the next resolution plan submission date of firms, to which the general guidance is directed.”

If the agencies want to keep that promise while producing guidance in time for the 2021 targeted plan cycle, they will need to seek public comment imminently – one resolution expert says banks are expecting a consultation as early as the first quarter of this year.

Alternatively, the agencies could aim to finalise new guidance for the 2022 full cycle. But that would potentially take the whole timeline beyond the presidential election in November 2020, introducing far more political uncertainty into the process.

The Fed and the Federal Deposit Insurance Corporation declined to comment for this article. 

More transparency please

As a confidential submission between a bank and its supervisor, RLAP and RLEN have been little discussed in public (see box: Life after death). But guidance on resolution liquidity was thrust briefly into the limelight in November, when it was cited among other regulatory factors by JP Morgan chief executive Jamie Dimon as contributing to the bank’s calculus that it should hold no less than $60 billion in reserves intraday at the Fed.

A proposal on the guidance is “the piece that the industry is waiting on”, says Mark House, managing director of consultancy Chain Bridge Partners, and a former programme manager of the Fed’s comprehensive liquidity assessment and review stress test. 

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Michael Krimminger

Fed vice-governor for supervision Randal Quarles has emphasised repeatedly – most recently in a speech on January 17 – that he wanted to improve the transparency of regulatory implementation.

At the January 29 press conference, Powell concurred. He described the tension between a desire for transparency and due process on the one hand and the requirements of confidential supervision on the other as a “very challenging question”, which will need “further development and lots of comment”. 

While the agencies are not required under the APA to issue a formal consultation on a piece of guidance, these interventions from Fed governors have raised expectations that they will choose to do so.

RLEN and RLAP requirements gold-plate the Basel LCR, which was implemented via a full notice of proposed rulemaking process. It is therefore appropriate that resolution liquidity guidance should now be subject to more formal consultation, says Michael Krimminger, partner at Clearly Gottleib and former general counsel at the FDIC.

“In many cases, these resolution requirements based on guidance have become the binding constraint on liquidity for large banks. It’s simply good public policy to make sure such important standards are presented for public comment and refined in response to that feedback, and that’s what they appear to be planning to do,” he says.

Inconsistent approach

Banks calculate their RLEN and RLAP requirements themselves. Since the confidential nature of reporting prevents firms from benchmarking themselves against peers, both House and Krimminger say it is unlikely the calculations are handled consistently among banks.

“Given the importance of these requirements for liquidity constraints, they should be put out for public comment, clarified in practice and applied consistently,” says Krimminger.

Noreika says the regulators previously kept their preferred methodologies private to stop banks trying to “game the system”, but he believes uncertainty over how to calculate RLEN and RLAP is one reason why they may have an impact on repo markets.

Although sources say there is little hard evidence that resolution liquidity planning actually constrains bank balance sheets in theory, fear of falling foul of unclear boundaries could make banks reluctant to take on extra market positions in practice.

I don’t have 100% confidence that it’s still not being applied
Coryann Stefansson, Sifma

“First of all, you’re seeing the practical externalised effects that the lack of clarity had… through things like the repo market. And, secondly, you have the notion of the rule of law: the police can’t pull you over for speeding when you’re driving down the street if they don’t tell you what the speed limit is until after you break it,” says Noreika.

Coryann Stefansson, head of prudential policy at the Securities Industry and Financial Markets Association (Sifma), says the effects of a lack of comprehensive resolution-planning guidance regarding liquidity expectations can be felt not only internally at the banks but perhaps through supervisory behaviour as well.

“The guidance is for the banks and for the supervisors, so it’s hard to say with any assurance that the regulators aren’t holding banks accountable to a standard that is not in the guidance,” she says. “The existing guidance doesn’t talk, for example, about this preference for cash versus securities [but]… I don’t have 100% confidence that it’s still not being applied.”

There is a widespread perception that banks should hold cash rather than treasury securities as high-quality liquid assets for meeting RLEN and RLAP requirements, even though the guidance doesn’t say this expressly. The resulting extra holdings of cash reserves at the Fed could be a factor eating into repo market liquidity.

Quarles alluded to this problem in a speech on February 6, when he noted: “It is worth considering whether financial system efficiency may be improved if reserves and treasury securities’ liquidity characteristics were regarded as more similar than they are today – that is to say that reserves and treasury securities were more easily substitutable in the context of liquidity buffers.”

Model risk

House picks out two other topics that could be priorities in terms of clarifying the guidance. The first is the treatment of inter-affiliate funding. Resolution plans require material entities of the bank holding company to demonstrate they would be able to put in place liquidity through, and even after, a resolution event.

However, the lack of specific guidance means banks are uncertain how to treat the funding and business relationship between affiliates; for example, between a banking unit and a broker-dealer arm.

“When you get to more complex matters, like inter-affiliate transactions within one global entity, there’s even more discretion such as the types of assumptions [that] examiners might make about liquidity being available or not available, and how that will affect meeting the requirements,” says Noreika.

It’s completely untested… whether a firm can actually quantify the amount of liquidity necessary to support their preferred resolution strategy
Mark House, Chain Bridge Partners

The second, perhaps thornier, problem is the expectation that firms will update their failure scenario estimate for liquidity needs on a real-time basis.

“That’s a really critical lynchpin to whether the preferred [resolution] strategy is executable,” says House.

He adds that supervisors have so far done little to verify or validate whether banks have the dynamic scenario-forecasting capabilities required to fulfil this expectation and underpin their resolution plans. He says banks could face a profound challenge from an operational and technology standpoint if the agencies step up their examinations of RLEN forecasting models.

“Firms can absolutely develop liquidity risk models in a business-as-usual environment, which they think are sufficiently conservative to quantify the various risks, but it’s completely untested at this point whether a firm can actually quantify the amount of liquidity necessary to support their preferred resolution strategy,” House warns. 

Tight deadline

Even if resolution liquidity guidance is at the front of the queue, it is not guaranteed that the agencies will finalise this in a presidential election year, according to Justin Slaughter, a partner at public policy consultancy Mercury Strategies. He was previously an aide to Sharon Bowen, who was a Democrat commissioner at the Commodity Futures Trading Commission between 2014 and 2017.

“Among financial regulators, there are not many major rules [that] people expect to get finished between now and November,” says Slaughter.

He also points to a lack of co-ordination between the financial regulatory agencies: “That could change, but that’s the general sense and overall state of play. A lot of co-ordination and momentum among these financial regulators disappeared after Gary Cohn left the White House in March 2018.”

This view is shared by John Court, general counsel at the Bank Policy Institute trade association, who suggests not all of the prudential regulators are equally interested in the resolution liquidity rules: “I think it’s the FDIC that’s really pushing it to be done.” 

Life after death

Resolution plans, or so-called “living wills”, require firms to develop a strategy that will allow the parent company to recapitalise and provide liquidity resources to its subsidiaries in the event that it enters resolution or bankruptcy proceedings. 

In a severe stress scenario, each of the bank holding company’s material entities must have sufficient capital and liquidity to maintain continuity of operations throughout resolution, and avoid multiple competing insolvencies.

RLAP requires the firm to estimate standalone liquidity needs for each material subsidiary over a minimum of 30 days of stress, and ensure sufficient liquidity is either pre-positioned in the subsidiary or otherwise available at the parent as high-quality liquid assets (HQLAs) to meet any deficits. 

RLEN requires the firm to further account for the estimated liquidity needed after resolution or bankruptcy at the parent level, to support the survival or wind-down of subsidiaries.

The combination of these two requirements means minimum liquidity levels at individual entities within the group mount up, potentially taking the aggregate requirement for HQLAs well beyond the Basel LCR.

Edited by Philip Alexander

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