Muni advocates wary of Basel III

Proposed bank regulations that require banks to raise significantly more capital and subject municipal bonds to a standardized treatment would drive up borrowing costs for cities and states, further reduce bank muni holdings and reduce municipal market liquidity.

That's the warning from critics of so-called Basel III Endgame, the final phase of the international rules intended to shore up banks after the 2008 global financial crisis.

The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation jointly issued a notice of proposed rulemaking on July 27. The proposal would substantially increase risk-based capital requirements for banks with more than $100 billion in assets, a move that regulators say is necessary to better reflect the risks of certain assets and to protect against bank failures. It would also require the biggest banks to include unrealized capital gains and losses on certain securities in their capital levels, a provision that came in the wake of the spring failures of three large banks.

The banking industry has launched an aggressive campaign against the rules, saying it would diminish lending to low-income Americans and small businesses, hurt pension funds and reduce clean energy investment by quadrupling capital requirements tied to renewable tax credits.

American Securities Association

For the municipal bond market, critics say the complex, 1,000-page proposal could translate into less market liquidity and increase issuers' financing costs.

"SIFMA is concerned that these punitive changes to the capital rules, without regard to the specific unique nature of the municipal debt markets, may result in reduced willingness for financial institutions to hold inventory and could lead to less liquidity, higher yields and lower market making activity in municipal bonds," said Leslie Norwood, managing director, associate general counsel and head of municipal securities at the Securities Industry and Financial Markets Association.

"Major market players have already taken steps to analyze whether to deploy their capital elsewhere and several firms have exited the municipal market as a result of many factors including the regulatory burden."

SIFMA, like other organizations including the American Securities Association, plans to submit comments on the proposal. Comments are due by Jan. 16, 2024. Dozens of state and local officials have already submitted comments warning that the proposal would hurt low-income and black and brown communities by tightening credit.

Even some federal regulators warn of increased financing costs resulting from the proposal. In July, the day regulators unveiled rulemaking, Federal Reserve Board Governor Michelle Bowman issued a statement warning "when a local government issues municipal bonds to finance local infrastructure, they may find that financing is more expensive, or in some cases unavailable."

The proposal would increase the required highest-grade capital by about 16% on average, according to a Brookings analysis. It would require that municipal bonds be treated as so-called posted collateral and subject to certain haircuts, which would increase the cost of capital from 8% to 20% needed to hold it on their books, Justin Underwood, the founder and managing principal of Flat98 Strategies & Communications, LLC, argued in a Nov. 30 Bond Buyer article.

By requiring more capital to be held against assets like municipal and corporate bonds than Treasury bonds, which have a risk weight of 0%, the proposal "incentivizes you to hold those securities that require the least amount of capital, which are treasuries," said Chris Iacovella, president and CEO of the American Securities Association. "That's going to crowd out muni, mortgage, and corporate bonds. That's why it negatively impacts the muni market's liquidity and why it's going to cause a problem in the next financial panic."

Because Basel III applies only to banks with $100 billion or more of assets, it would seem at first glance to benefit smaller and regional firms like the ones who make up ASA's membership, Iacovella said. But the proposal actually "decreases the amount of liquidity in the space and that's not good for the trading of muni and mortgage bonds," he said. "When there's less liquidity in the marketplace that means that the price goes up and that raises the cost for issuers. That's a regulatory cost effect, it's not because the finances of the issuers have changed."

Lawmakers are scrutinizing the proposal, with most Republicans already opposed and even some Democrats starting to question the rules.

More than 100 lawmakers sent a Dec. 18 letter to bank regulators urging them to revise the tax equity provisions in the rules. In November, a group of 39 Senate Republicans, led by Sen. Tim Scott, R-S.C., the ranking member of the Senate Banking Committee, wrote to regulators asking them to withdraw the entire proposal and begin a new process. 

But many Democrats remain supportive. At a Dec. 6 Senate Banking Committee hearing with the CEOs of the top Wall Street banks, committee chair Sen. Sherrod Brown, D-Ohio, accused the banks of pouring money into the lobbying campaign against the rules. "What your banks want is to maximize quarterly profits – the cost to everything and everyone else be damned," Brown said.