New Quantitative Liquidity Requirements
Proposed
October 29, 2013
On October 24, 2013, the Board of Governors of the Federal Reserve System (the “Federal
Reserve”) issued a notice of proposed rulemaking that would establish, for the first time, aquantitative minimum liquidity coverage ratio (“LCR”) for large, internationally active banking
organizations, as well as for certain systemically important nonbank financial companies
designated by the Financial Stability Oversight Council (the “FSOC”) for Federal Reserve
supervision (“nonbank SIFIs”). 1 A modified version of the LCR would apply to depository
institution holding companies that are not internationally active, but have at least $50 billion in
total consolidated assets (the “Modified LCR”). By requiring banking organizations to hold astock of high quality liquid assets (“HQLA”) sufficient to survive a sustained acute liquidity
stress scenario, the proposal aims to avoid the liquidity squeeze and subsequent deterioration offinancial markets experienced during the 2007-2008 financial crisis.
Once implemented, the rule, to be known as “Regulation WW,” establishes the firststandardized metric of short-term liquidity risk across banking organizations, complementing
the existing supervisory approach of assessing liquidity risk management practices on a caseby-case basis and the more qualitatively focused liquidity requirements recently proposed by
the Federal Reserve for very large banking organizations and nonbank SIFIs. 2 Although largely
consistent with the international LCR published by the Basel Committee on Banking
Supervision (the “BCBS”), 3 the proposed rule is more stringent in several respects. Most
notably, the proposed rule includes an accelerated transition period, allows fewer types of1

Both the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency
are expected to approve the proposed rule on October 30, 2013.

2

Pursuant to Section 165 of the Dodd-Frank Act, the Federal Reserve issued two proposals in late2011 and 2012 that establish, among other things, enhanced liquidity standards for large U.S.
banking organizations, certain large non-U.S. banking organizations that are subject to the Bank
Holding Company Act, and nonbank SIFIs. Largely qualitative in nature, these enhanced liquidity
standards address such things as corporate governance provisions, senior management
responsibilities, a requirement to hold highly liquid assets to cover stressed liquidity needs based oninternally developed stress models, the development of a contingency funding plan and specificlimits on potential sources of liquidity risk. For background on these two proposals, which remain
pending, please see our memoranda, titled “Regulating Systemically Important Financial
Companies,” dated January 10, 2012, available atand“New
http://www.stblaw.com/siteContent.cfm?contentID=4&itemID=75&focusID=1356,
Regulatory Framework for Foreign Banks with U.S. Operations,” dated December 19, 2013, available
at http://www.stblaw.com/siteContent.cfm?contentID=4&itemID=75&focusID=1555.

3

BCBS, “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” (January 2013),
available at http://www.bis.org/publ/bcbs238.htm.

Memorandum – October 29, 2013

assets to qualify as HQLA, and incorporates more conservative assumptions regarding a firm’s
net cash outflow during the stress period. While noting the importance of the proposed LCR in
advancing the Federal Reserve’s liquidity risk oversight program, Governor Daniel K. Tarullo
signaled that additional regulatory reform may be forthcoming to further address potential
liquidity problems at large banking firms. Comments on the proposal are due by January 31,
2014.
A.

SCOPE OF APPLICATION

The proposed rule would generally impose the minimum LCR requirement on any U.S.
banking organization (e.g., bank holding companies, savings and loan holding companies, anddepository institutions) that (i) has $250 billion or more in total consolidated assets, (ii) has $10
billion or more in total consolidated on-balance sheet foreign exposure, or (iii) is a depository
institution subsidiary of an organization described in (i) or (ii) and has $10 billion or more in
total consolidated assets. Top-tier U.S. bank holding companies and savings and loan holding
companies with less than $10 billion in on-balance sheet foreign exposure and total consolidated
assets between $50 billion and $250 billion would be subject to the Modified LCR. A banking
organization which does not meet the asset thresholds for automatic application of the LCR or
Modified LCR may nevertheless be subject to the LCR requirement if the applicable federalbanking agency determines that application would be appropriate in light of the company’s
asset size, complexity, and risk profile (subject to notice and response procedures establishedunder the prompt corrective action provisions of the Federal Deposit Insurance Act).
The minimum LCR requirement would also apply to certain nonbank SIFIs, 4 regardless of asset
size.
Notably, top-tier bank holding companies and savings and loan holding companies andnonbank SIFIs with substantial insurance activities (i.e., companies that perform insurance
underwriting activities or hold at least 25% of their total assets in subsidiaries that performinsurance underwriting activities) and top-tier savings and loan holding companies with
substantial commercial operations (i.e., grandfathered unitary thrift holding companies with
50% or more of their total consolidated assets or revenues on an enterprise-wide basis derived
from activities that are not covered by Section 4(k) of the Bank Holding Company Act) are notsubject to the proposal. This exemption reflects the Federal Reserve’s view that the liquidity
requirements in the proposed rule were not designed to address the liquidity risk profile ofinsurance companies.
B.

THE MINIMUM LCR REQUIREMENT

Upon taking full effect, the proposed rule would require a covered institution to achieve andmaintain an LCR of at least 100%. The LCR would be calculated as the ratio of two components:(i) the value of the firm’s stock of high quality liquid assets under stressed conditions; and (ii)total projected net cash outflows during a 30-day stress scenario (or, in the case of the Modified
LCR, during a 21-day stress scenario).
4

To date, the FSOC has made three nonbank SIFI designations: American International Group,
General Electric Capital Corporation, and Prudential Financial.

Page 2

Memorandum – October 29, 2013

1.

The LCR Numerator: High Quality Liquid Assets

To achieve the LCR’s goal of ensuring sufficient liquidity during an acute stress scenario, assets
to be counted towards the minimum LCR as HQLA must be readily convertible into cash,
through sale or secured borrowing, with little or no loss of value during a period of liquidity
strain. Accordingly, the proposed rule requires all HQLA to satisfy the following criteria:•“Liquid and Readily Marketable”—Securities included in HQLA must be tradedin an active secondary market with more than two committed market
makers, a large number of non-market maker participants on both the buying
and selling sides of transactions, timely and observable market prices, and ahigh trading volume.

•“Unencumbered”—All assets included in HQLA must be free of legal,
regulatory, contractual, or other restrictions on the ability of the firm tomonetize the asset, and the assets must not be pledged to secure or provide
credit enhancement to any transaction. Assets may nevertheless be includedin HQLA if they are pledged to a central bank or U.S. government-sponsoredenterprise (“GSE”).

•“Not an Obligation of a Regulated Financial Company”—Assets included in
HQLA must not be issued by financial sector entities, since such assets would
carry wrong-way risk correlation with covered institutions.

•

Separate Assets of the Bank—Assets included in HQLA must not be designatedto cover operational costs of the covered banking organization, and must not
be securities owned by a customer of the covered banking organization,
regardless of the banking organization’s hypothecation rights to thecustomer’s securities.

The proposed rule further divides qualifying HQLA into three sub-categories, based on
the nature of the asset and its issuer. Because the three HQLA categories involve varying
risk profiles, each would be subject to corresponding caps and asset-value “haircuts,” asdescribed below. The LCR numerator would then be calculated by summing the riskadjusted asset values from each of the following HQLA categories:•

5

Level 1 Liquid Assets: Assets with the highest potential to generate liquidity for acovered institution during periods of acute liquidity stress. Level 1 assets would be
included in the HQLA amount without limit, and without being subject to a valuebased haircut. Under the proposed rule, Level 1 assets include (i) excess reserves
held at the Federal Reserve; (ii) withdrawable reserves held at a foreign central bank;(iii) securities issued by, or guaranteed by the full faith and credit of, the U.S.
government; and (iv) certain securities issued by or guaranteed by a foreign
sovereign, central bank, or other international entity that are assigned a 0% risk
weight under the standardized approach of the revised regulatory capital rules. 5

This generally would include all OECD sovereign debt unless the debt was in default or restructured
consistent with the Federal Reserve’s recently revised capital regulations under Basel III. See 78 Fed.
Reg. 62018 (Oct. 11, 2013).
Page 3

Memorandum – October 29, 2013•

Level 2A Liquid Assets: Level 2A assets would be included in the HQLA amountsubject to a 15% haircut off the assets’ current market value. The combined values ofLevel 2A and Level 2B assets could not comprise more than 40% of a covered
institution’s total HQLA stock, after applicable haircuts have been applied. Under
the proposed rule, Level 2A assets would include (i) claims on or guaranteed by a
GSE that are investment-grade and senior to preferred stock in the GSE, and (ii)claims on or guaranteed by a foreign sovereign or multilateral development bankthat are assigned a 20% risk weight under the standardized approach of the revised
regulatory capital rules.

•

Level 2B Liquid Assets: Level 2B assets would be included in the HQLA amountsubject to a 50% haircut off the assets’ current market value. The combined values ofLevel 2A and Level 2B assets could not comprise more than 40% of a covered
institution’s total HQLA stock, after applicable haircuts have been applied. Level 2B
assets could comprise no more than 15% of a covered institution’s total HQLA stock,after applicable haircuts have been applied. Under the proposed rule, Level 2B assets
would include (i) investment-grade, publicly traded corporate debt securities, and(ii) publicly traded equity securities that are included in the Standard & Poor’s 500
Index (or an equivalent acceptable index).

COMPARISON OF CERTAIN ASSET CATEGORIES
U.S. Proposal
BCBS
HQLA Category
HQLA Category
Claims On or Guaranteed by
Level 2A
Level 1
U.S. GSEs
Investment-Grade Corporate
Level 2B
Level 2A
Debt Securities
Non-Investment-Grade
Corporate Debt Securities

Not HQLA

Level 2B

Private Label Residential
Mortgage-Backed Securities 6

Not HQLA

Level 2B
(subject only to a 25% haircut)

As illustrated in the table above, the proposed rule is considerably more stringent than the
BCBS approach in that some categories of assets, such as non-investment-grade corporate debt
6

During the Federal Reserve’s open meeting on October 24, 2013, a member of the Federal Reserve
staff stated that, in contrast to the BCBS approach, some assets such as “private label mortgagebacked securities” are indeed excluded from the proposal as liquid assets “due to the relative lack ofliquidity and other factors.” Transcript of Open Meeting of the Federal Reserve (Oct. 24, 2013),
http://www.federalreserve.gov/mediacenter/files/open-board-meeting-transcriptavailable
at20131024.pdf. The proposal does not explicitly address the treatment of residential mortgage-backed
securities that are issued or guaranteed by a GSE, but because the proposal includes securities issued
by a GSE in Level 2A HQLA if such securities are investment-grade and “senior to preferred stock” in
the GSE, residential mortgage-backed securities issued or guaranteed by a GSE should be included in
Level 2A HQLA.

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Memorandum – October 29, 2013

securities and private label residential mortgage-backed securities, will have no value forpurposes of U.S. liquidity requirements.
2.

The LCR Denominator: Total Net Cash Outflow

The amount of HQLA held by covered institutions would need to be sufficient to offset thefirm’s total net cash outflow amount during the relevant liquidity stress period. To calculate its
total net cash outflow for purposes of the LCR requirement, a covered firm would first calculate
its daily net cash outflow each day during the stress period, by subtracting that day’s expectedcash inflow from that day’s expected cash outflow. The firm would then calculate its cumulative
net cash outflow for each day during the stress period, by summing the daily net cash outflows
for each preceding day during the stress period. 7 The firm’s total net cash outflow (the LCR
denominator) would then be equal to the peak cumulative net cash outflow (i.e., the cumulative
net cash outflow that is higher than any other day’s cumulative net cash outflow during thestress period).
This calculation differs significantly from that involved in the BCBS LCR. Rather than selecting
the peak cumulative net cash outflow, the BCBS LCR sets as its denominator the total
cumulative net cash outflow, summed over the course of the entire stress period. The federalbanking agencies view the proposal’s methodology as an improvement over the BCBS
methodology, since it takes into account the risk that a covered company could have asubstantial amount of cash inflows late in the stress period while also having substantial
outflows early in the same period.
The proposed LCR requirement contemplates a stress test period lasting 30 days after eachcalculation date, while the proposed Modified LCR requirement contemplates a stress period
lasting 21 days after each calculation date.
SIMPLIFIED COMPARISON OF TOTAL NET CASH OUTFLOW CALCULATIONS(5 DAY STRESS PERIOD)
Total Net Cash Total Net Cash
Day
Day
Day
Day
Day
Outflow
Outflow
1
2
3
4
5(U.S. Proposal)(BCBS)
Daily Cash
100
100
100
100
100
Outflow
Daily Cash
0
25
50
125
150
Inflow
225
150
Daily Net Cash
100
75
50
(25)
(50)
Outflow
Cumulative Net
100
175
225
200
150
Cash Outflow

7

In calculating cumulative net cash outflows, cumulative cash inflows would be capped at 75% of
cumulative cash outflows. This cap would prevent a company from relying exclusively on projectedcash inflows to cover its liquidity needs, since such inflows may not materialize in a period ofliquidity strain.

Page 5

Memorandum – October 29, 2013(i)

Stressed Cash Outflows

The proposed rule includes various predetermined run-off rates to be used in calculating
projected cash outflow, which are intended to approximate outflows experienced during
periods of severe liquidity stress. The run-off rates are consistent with those included in the
BCBS LCR, and vary based on the source of the covered firm’s funding. Examples of relevant
run-off rates in the proposed rules include:•

Unsecured Retail Funding Cash Outflow—Outflow rates would range from 3%
for stable retail deposits that are fully FDIC-insured to 40% for uninsured
retail brokered sweep deposits. Brokered deposits that are entirely coveredby FDIC deposit insurance would have an outflow rate of 10%, if issued by aconsolidated subsidiary, and 25%, if not issued by a consolidated subsidiary.

•

Unsecured Wholesale Funding Cash Outflow—Outflow rates would range from
25% for operational deposits to 100% for commercial paper or nonoperational deposits from financial entities.

•

Secured Short-Term Funding Cash Outflow—Outflow rates would correspondto the liquidity characteristics of the collateral, including 0% for funding
secured by Level 1 HQLA, 15% for funding secured by Level 2A HQLA, 50%
for funding secured by Level 2B HQLA, and 100% for funding secured by
non-HQLA.

•

Commitments Cash Outflow—Outflow rates would range from 5% forundrawn retail credit facilities to 40% for most undrawn corporate credit
facilities, and 50% for undrawn credit facilities to banks.
(ii)

Stressed Cash Inflows

In calculating projected cash inflow, the proposed rule would specifically exclude fromcash inflows several categories of items that the federal banking agencies consider to be
insufficiently reliable sources of liquidity during a stressed scenario. Items that would
not be counted towards a covered firm’s cash inflows include (i) operational deposits
that the covered firm holds at other regulated financial companies; (ii) amounts that thecovered firm expects to receive from mortgage-related derivative transactions; (iii)amounts arising from credit or liquidity facilities extended to the covered firm; (iv) any
assets that the covered firm has included in its HQLA amount, and any amounts
payable to the covered firm with respect to those assets; (v) outstanding exposures thatare nonperforming as of the calculation date, or which the covered firm has reason to
expect will become nonperforming within the stress period; and (vi) items that have nocontractual maturity date.
For non-excluded inflow items, the proposed rule includes various assumed inflow rates
which are meant to reflect the likelihood of the projected inflow items materializing
during a stressed liquidity scenario. Examples of relevant inflow rates in the proposed
rules include:

Page 6

Memorandum – October 29, 2013

C.

•

Unsecured Retail Cash Inflow—A covered firm could count as inflow 50% of allcontractual payments it expects to receive from retail customers within theapplicable stress period.

•

Unsecured Wholesale Cash Inflow— A covered firm could count as inflow 100%of all wholesale inflows (including principal and interest) it expects to receivefrom regulated financial companies, investment companies, non-regulated
funds, pension funds, investment advisers, and central banks. However, acovered firm could count as inflow only 50% of inflows due from wholesalecustomers that are not regulated financial companies, investment companies,
non-regulated funds, pension funds, investment advisers, or central banks.

•

Secured Short-Term Lending Cash Inflow—Inflow rates would correspond to theliquidity characteristics of the collateral, including 0% for lending secured by
Level 1 HQLA, 15% for lending secured by Level 2A HQLA, 50% for lending
secured by Level 2B HQLA, and 100% for lending secured by non-HQLA.

•

Securities Cash Inflow— A covered firm could count as inflow 100% of allcontractual payments it expects to receive from securities owned by thecovered firm that are not included in the firm’s HQLA amount.

MECHANICS OF THE LCR REQUIREMENT

The proposed rule would require a covered institution to calculate its LCR daily, as of aconsistent time of day. The time of day at which a company would calculate its LCR would beselected by the company prior to the proposed rule’s effective date, and would becommunicated in writing to the company’s primary federal banking regulator. Upon making
this election, any change in the time of day at which a covered institution calculates its LCR
would require the written approval of its primary federal banking regulator.
In addition to requiring that covered firms hold a minimum stock of HQLA, the proposed rulewould impose certain operational requirements to ensure that a firm’s stock of HQLA could be
efficiently liquidated in times of stress. To this end, covered institutions would be required todemonstrate the following capabilities:•

Determining the Composition of HQLA—As part of its ongoing monitoring of
HQLA, a covered firm would need to exhibit a command over the locationand diversification of its HQLA, while ensuring that the assets included in its
HQLA stock continue to qualify as HQLA.

•

Monetizing HQLA If and When Necessary—A covered firm would be required
to implement appropriate systems allowing it to monetize its HQLA at any
time, and would be required to periodically monetize a sample of its HQLA
that reflects the composition of the firm’s broader HQLA portfolio to confirm
access to relevant markets.

Page 7

Memorandum – October 29, 2013•

Controlling HQLA Under the Firm’s Liquidity Risk Management Function—A
covered firm’s liquidity risk management function would need to have fullauthority to liquidate HQLA when necessary, as well as full access to funds
resulting from monetized HQLA, without conflicting with another businessor risk management strategy.

The proposed rule would require covered firms to notify their primary federal banking
regulator on any business day that its LCR is below the required minimum LCR, butallows for a flexible supervisory response to the inadequate LCR. This flexibility islargely in recognition that a covered firm may occasionally need to access its HQLA tofund unanticipated liquidity needs. However, if a covered firm’s LCR were to remain
below the minimum requirement for three consecutive business days, the covered firm
would be required to submit a plan for remediation to its primary federal banking
regulator. The federal banking agencies would have discretionary authority to takesupervisory or enforcement actions to address noncompliance with the LCR
requirement.
D.

GENERAL TIMINGThe proposed rule contemplates full compliance with the LCR by January 1, 2017, but adopts aphase-in transition period to mitigate the burden of compliance on covered institutions andfinancial markets. Covered institutions would be required to achieve an LCR of at least 80% by
January 1, 2015, and an LCR of at least 90% by January 1, 2016. Beginning January 1, 2017,
covered institutions would be required to maintain an LCR of at least 100% on an ongoing basis.
By contrast, as illustrated in the table below, the BCBS LCR includes an extended transition
period and would not require full compliance until January 1, 2019. Under the BCBS phase-inplan, the minimum LCR for covered institutions will be set at 60% beginning January 1, 2015,
and will thereafter increase by 10% annually until January 1, 2019.
COMPARISON OF LCR TRANSITION PERIODS
January 1,
2015

January 1,
2016

January 1,
2017

January 1,
2018

January 1,
2019

Minimum LCR(U.S. Proposal)

80%

90%

100%

100%

100%

Minimum LCR(BCBS)

60%

70%

80%

90%

100%

The federal banking agencies have justified the proposed rule’s accelerated timeline based on
the perceived importance of the LCR in promoting a healthy banking sector, and on their desire
to reinforce the improvement of liquidity positions since the financial crisis.

Page 8

Memorandum – October 29, 2013E.

ADDITIONAL LIQUIDITY-RELATED INITIATIVES AROUND THE CORNER

In a prepared statement, Governor Tarullo noted that the proposed LCR requirement marks an“important advance in prudential regulation,” but cautioned that the LCR alone is “notsufficient to address potential liquidity problems at large banking firms.” In particular,
Governor Tarullo noted that while the LCR creates a liquidity cushion sufficient to cover a 30day stress scenario, liquidity strains can last considerably longer. To address such longer-term
liquidity strains, the BCBS included in its 2010 liquidity framework a minimum net stable
funding ratio (“NSFR”), which would ensure that covered institutions finance long-term assets
with sufficient long-term, stable funding. The BCBS is currently in the process of reviewing its
2010 proposed NSFR, and the federal banking agencies are considering what changes to the
NSFR they may recommend to the BCBS. Governor Tarullo stated that the BCBS is “well alongin creating a final [NSFR] product,” and expressed his anticipation that the Federal Reserve
would propose a U.S. NSFR rule consistent with the final BCBS rule.
In focusing on the liquidity of individual firms, both the proposed LCR and the forthcoming
NSFR represent microprudential advances in liquidity reform. Governor Tarullo noted,
however, that the LCR does not address the macroprudential risks existing in the modernbanking sector, such as large negative externalities caused by asset fire sales and theinterconnectedness resulting from widespread matched-book financing. According to Governor
Tarullo, regulatory measures addressing such macroprudential concerns, particularly systemicrisks posed by banks’ use of short-term wholesale funding, should rank among the Federal
Reserve’s “highest remaining priorities.”**

Page 9*Memorandum – October 29, 2013

For more information, please contact a member of Simpson Thacher’s Financial Institutions
Group.
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Lesley Peng
(212) 455-2202
lpeng@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Roxane Reardon(212) 455-2758
rfreardon@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

Andrew Keller(212) 455-3577
akeller@stblaw.com

Spencer Sloan(212) 455-7821
spencer.sloan@stblaw.com

This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we informyou that any tax advice contained in this memorandum was not intended or written to be used, andcannot be used, for the purpose of avoiding tax-related penalties under federal, state or local tax law.
Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independenttax advisor.
The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

Page 10Memorandum – October 29, 2013

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