Vice Chair Barr Discusses Targeted Adjustments to Liquidity Framework

On May 20, 2024, Federal Reserve Vice Chair for Supervision Michael S. Barr discussed three proposed targeted adjustments to bank liquidity risk management and the Federal Reserve’s discount window at the 28th Annual Financial Markets Conference of the Federal Reserve Bank of Atlanta. As discussed in our February 2024 Advisory, Barr’s remarks were another sign of increased regulatory scrutiny on bank liquidity risk management and operational readiness to use the Federal Reserve’s discount window, following the collapse of three large banking organizations in the spring of 2023. Depositors at these institutions, including high-net-worth individuals and companies, withdrew funding at rates that “greatly exceed the assumptions made in [regulators’] current, standardized liquidity requirements.” In January, Acting Comptroller Michael J. Hsu mooted possible changes to liquidity requirements, including the requirement that midsize and large banks have sufficient liquidity to cover outflows over a five-day period. Barr’s remarks represent the likely path of regulatory change that the Federal Reserve is exploring in this area.

Remarks by Vice Chair for Supervision Michael S. Barr

To ensure a strong and stable financial system, banks must have the capacity to remain resilient in times of stress. For Barr, the requirement to hold “high-quality liquid assets that are commensurate with the size and likelihood of sudden funding outflows” constitutes a “form of self-insurance against unanticipated funding shocks” faced by banks. And although no amount of liquidity risk management can guarantee a bank’s survival amid a bank run, Barr suggests that ample liquidity resources may help to stabilize banks experiencing stress, as well as limit the potential for contagion in the financial system.

In an effort to improve liquidity resilience and ensure that all large banks maintain better liquidity risk management practices, Barr said that the Federal Reserve is exploring the following three “targeted adjustments”:

1. Pre-Positioned Collateral at the Discount Window. According to Barr, the Federal Reserve is exploring a new requirement that “banks over a certain size maintain a minimum amount of readily availability liquidity” through “a pool of reserves and pre-positioned collateral at the discount window,” which would be “based on a fraction of their uninsured deposits.” The Federal Reserve has observed depositors quickly withdrawing uninsured deposits, if deposit availability is in doubt, given that uninsured deposits “often represent cash needed to meet near-term needs.” Moreover, Barr suggested that such a readiness requirement would signal regulatory approval of “use of the discount window as appropriate and unexceptional under both normal and stressed market conditions.” Barr also stated that the Federal Reserve is committed to improving the operational capabilities of the discount window, which has become a subject of criticism over the past year.¹

2. Reliance on Held to Maturity (HTM) Assets. Barr noted that the Federal Reserve is exploring a restriction “on the extent of reliance on [HTM] assets in large banks’ liquidity buffers” to address challenges with monetization amid stress. The Federal Reserve’s restriction on HTM assets would include “those held under the liquidity coverage ratio (LCR) and the internal liquidity stress test (ILST) requirements.” To note, LCR measures the proportion of high-quality liquid assets held by a bank to fund cash outflows for 30 days, whereas ILST measures the potential impact of certain liquidity stress scenarios on a bank’s cash flows, liquidity positions, profitability, and solvency. Currently, regulators permit a bank to make use of HTM assets in the LCR and ILST calculations.

3. Deposit Outflow Assumptions. Barr stated that the Federal Reserve is reviewing its deposit outflow assumptions in its liquidity rules with respect to “high-net-worth individuals and companies associated with venture capital or crypto-asset-related businesses.” Barr reiterated concern with the speed at which these types of depositors were withdrawing funds during the banking turmoil of the spring of 2023. Deposit outflow assumptions are embedded in LCR, which distinguishes “stable” retail deposits insured by the Federal Deposit Insurance Corporation from other “less stable” deposits.² Moreover, comprehensive contingency funding plans, which are designed to ensure that banks have sufficient funds to meet liquidity needs, must address deposit outflows.³ Neither LCR nor comprehensive contingency funding plans matched the speed of outflows experienced in recent bank failures.

Further Remarks at the Annual Financial Markets Conference

Amid other discussions at the conference, Bill Nelson, Executive Vice President and Chief Economist of the Bank Policy Institute, agreed with Barr’s recommendation to add “a new requirement that banks have enough cash and discount-window borrowing capacity to meet a run on their deposits.” However, Nelson advised against writing such a rule “as a simple fraction of uninsured deposits,” instead suggesting that it be “incorporated into a requirement on [bank] contingency plans.” Nelson cautioned that rigid reserve requirements may reduce, rather than enhance, the resilience of the banking system.⁴

For more information about how adjustments to liquidity risk management requirements and the Federal Reserve’s discount window may impact your business, please contact any of the authors of this Advisory or your usual Arnold & Porter contact. The firm’s Financial Services team would be pleased to assist with any questions about the targeted adjustments referenced by Barr and Hsu, liquidity risk management, or financial regulation more broadly.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.