The fight over a capital surcharge for the largest banks took center stage in 2011, at least in the international Basel III process, as the chief executives of some major banks publicly clashed with regulators over the issue.

The industry failed to sway regulators from instituting such a charge, but bankers are hopeful they can have a bigger impact on first-time proposed liquidity rules, which are expected to be a top issue in 2012.

"Clearly the issue will be liquidity. That's always been a sleeper issue. Everybody focused on capital under Basel III, and it's liquidity that is the real major problem," said H. Rodgin Cohen, a partner with Sullivan & Cromwell and one of nation's top banking lawyers.

Unlike capital rules, which regulators have labored over for decades, the drive to create liquidity standards is an entirely new process. During the financial crisis, firms that were well capitalized failed quickly because of a relative lack of liquidity.

Under the Basel III plan, firms are being required to meet both a short-term and long-term liquidity requirement. Since its release last year, however, the plan has worried bankers, who consider it unworkable.

Regulators are already showing signs they are willing to listen to those concerns, including agreeing in September to take steps to give banks more time to prepare for the rules. Federal Reserve Board Gov. Daniel Tarullo has also explicitly said regulators are willing to make adjustments to the proposed liquidity framework.

"While we have had quantitative capital rules for a quarter century, this was the first effort at quantitative liquidity rules, so many central bankers and regulators wanted to be sure there would not be negative unanticipated consequences from this very important addition to prudential standards," Tarullo said in an interview with ASR sister publication American Banker.

The plan calls for institutions to develop a liquidity coverage ratio, or LCR, that is designed to meet short-term liquidity needs typically in a 30-day period. It also would require a net stable funding ratio for longer-term needs. The first ratio is to take effect in 2015 and the second in 2018.

The Fed has taken steps, however, to assure bankers that it will not institute the international liquidity requirements until there is a greater consensus on how to proceed.

In a proposal issued in late December, the central bank said that for now banks can rely on internal modeling in their own stress tests to ensure proper liquidity rather than forcing compliance with the Basel III proposal.

Still, regulators are hoping to work out problems with the international liquidity plan in 2012.
"A good bit of preparatory work has been done, and I think you will see quite a bit of progress [in 2012] toward agreement on some changes in the LCR," Tarullo said.

One concern — shared by U.S. regulators — is whether the liquidity rules can work as intended.
"The LCR was drafted in the middle of the financial crisis, so the Basel Committee didn't have the benefit of knowing what forms of liquidity had or had not held up well during the entire course of the crisis," Tarullo said.

So, for example, regulators are still asking fundamental questions: Were assets as liquid as they thought? What kinds of liabilities would run off quickly in a crisis? Had they thought about the impact of these requirements on financial markets?

Without getting into specifics, Tarullo has suggested in speeches that proposed changes would include a "recalibration of certain deposit runoff and commitment draw-down rates," as well as adjustments made to the buffer definition.

Despite the incompleteness of some of these proposals under Basel III, industry observers acknowledged the pressure facing regulators to press ahead to meet certain commitments made by the leaders of the Group of 20.

"I think the Basel Committee really ran 100 miles per hour to get its work done and to get all of the concepts out there," said Ernest Patrikis, a partner at White & Case and former general counsel of the Federal Reserve Bank of New York. "I think they were under a lot of pressure. I would not regard what they did as perfect, but sometimes you have to settle for the good over the perfect."

Unlike with the surcharge debate, however, regulators have been much more open to hearing out the industry on constructive fixes for the liquidity plan.

"It's the first real opening to compromise on any of these rules," said Karen Shaw Petrou, a partner at Federal Financial Analytics.

Both sides believe it has been — and will continue to be — a constructive dialogue given the rule's far-reaching implications.

"The regulators are focused on the feedback. Based on what they've said publicly, it appears some changes will be made, although it is not yet clear what those will be," said Adam Gilbert, managing director, head of regulatory policy, corporate risk for JPMorgan Chase & Co.
One area where firms see problems is that the current proposal calls for the market to be bifurcated between assets that are risk-weighted at zero and others that are given a 100% weighting, like cash and U.S. Treasuries.

"The world's much more nuanced than that," Gilbert said. Regulators would be better off taking a wider swath of liquid assets that would receive proper haircuts, he argued.

Another major concern is the assumptions of commitment draw and the treatment of deposit outflows, especially for nonretail.

Regulators have already begun work on many of these issues, but it's too early in the process to know how they will proceed.

Of equal importance for regulators is how they will determine just how liquid an asset must be to review any possible loss of value in an instrument. Policymakers are hoping to finalize changes by next summer, and would then later align those rules with the Fed's recent rulemaking process.
But liquidity will not be the only priority for Basel in 2012. Regulators have to go back and spend time refining how they identify systemically important firms; identifying a new set of domestically important banking companies that will likely adhere to higher capital and liquidity requirements; and ensuring all firms are implementing the rules consistently.

"I think there will be an increased focus on — and the banks will certainly point to — the ability to monitor competitive equality across the globe," said Greg Lyons, a partner at Debevoise & Plimpton. "I think it's a very difficult thing to do and I think as banks start to feel more and more pressure on these capital rules there will be more and more focus on making sure everybody faces pressure."

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