As regulators propose and ultimately make new rules around asset classes, they can create huge supply and demand imbalances. They can create bubbles or they can make liquidity dry up. So, what are tax-free retail investors and savers supposed to think if they are potentially going to be competing even that much more with big banks in buying the same tax-free municipal bonds that they have been investing in for decades?

The Federal Reserve Board released a news communication on Thursday that it is proposing to add certain general obligation state and municipal bonds to the range of assets which banks can use to satisfy certain regulatory requirements. Those regulatory requirements are said to be designed to ensure that large banking organizations have the capacity to meet their liquidity needs during a period of financial stress.

Reuters commented on this back in April. The news agency said that cities and states have been urging the Fed and other regulators to classify their investment grade bonds as highly liquid assets. The article said, “Fed officials had at that time said they did not think the rule would have significant implications for the $3.7 trillion municipal bond market.”

As a reminder, many banks already own muni bonds. The site BondBuyer.com showed that banks held close to $210 billion in combined municipal bonds at the end of 2011. Also, the St. Louis Federal Reserve showed that banks had raised their exposure to muni-bonds further in 2013.

The issue to consider here is what could happen if banks get to move these invested assets into the high-quality liquid assets category to help them meet regulatory requirements. Would the banks want to drastically increase their muni-bond buying? Now take the question one step further — If big banks are able to buy up more of the municipal bonds, how will that impact the prices that retail investors have to pay for tax-free bonds?

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For starters, not all muni-bonds would be allowed to qualify as high-quality liquid assets. The proposed rule was shown to allow banks to hold investment grade, general obligation U.S. state and municipal bonds that could be counted toward their high-quality liquid assets up to certain levels — if they meet the same liquidity criteria that currently apply to corporate debt securities. The Fed also indicated that the limits on the amount of a state’s or municipality’s bonds that could qualify are based on the specific liquidity characteristics of the bonds.

The Fed’s release said:

Under the Liquidity Coverage Ratio (LCR) requirement adopted by the federal banking agencies last September, large banking organizations are required to hold high-quality liquid assets (HQLA) that can be easily and quickly converted into cash within 30 days during a period of financial stress. Subsequent study by the Federal Reserve suggests that certain general obligation U.S. state and municipal bonds should qualify under the LCR as HQLA because they have liquidity characteristics sufficiently similar to investment grade corporate bonds and other HQLA asset classes.

The proposed rule would apply only to entities subject to the Liquidity Coverage Ratio and supervised by the Federal Reserve:

• Bank holding companies, certain savings and loan holding companies, and state member banks with $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure;
• State member banks with $10 billion or more in total consolidated assets that are subsidiaries of the above entities; and
• Bank holding companies and certain savings and loan holding companies with $50 billion or more in total consolidated assets, to which a less stringent Liquidity Coverage Ratio applies.
• No bank that is a subsidiary of a holding company with less than $50 billion in assets is required to meet any Liquidity Coverage Ratio requirement.

The Fed further said:

The recent financial crisis highlighted the need for enhanced liquidity risk-management practices at the largest financial institutions. Financial institutions with sufficient liquidity reserves are better able to mitigate the risks of creditor and counterparty runs. The proposed rule released Thursday would maintain the strong liquidity standards of the Liquidity Coverage Ratio while providing banks with the flexibility to hold a wider range of high-quality liquid assets.

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It is always hard to know if allowing new assets to be counted differently will squeeze prices (and therefore the equivalent after-tax spreads) too much, some, or even at all. Again, many banks already own municipal bonds. Stay tuned.

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