City and state treasurers struggling to make their budgets balance would get a big break if the regulatory relief bill that passed the Senate last week becomes law.
The bipartisan bill was advertised as aid for community and regional banks suffering under burdensome rules that were intended for Wall Street megabanks, but at least one provision affects big banks exclusively, including the biggest ones such as JPMorgan Chase and Citigroup.
It’s a measure that would encourage them to hold more municipal debt, an idea that has support from all over the political spectrum, from Senate Minority Leader Chuck Schumer to conservative Republicans. It’s such a popular move that it hasn’t even been a big part of the debate over the bill, authored by Banking Committee Chairman Mike Crapo, even as liberals led by Sen. Elizabeth Warren, D-Mass., mounted a concerted campaign against the legislation as a giveaway to big banks.
The provision hasn’t attracted much notice even though it could raise the risk of a banking crisis.
Here’s what the provision would do: One of the major new post-crisis banking rules is a requirement that the biggest banks maintain enough “liquid” assets that they would be able to stay afloat for at least 30 days just by selling off those assets.
The most liquid assets available are cash and Treasury securities. Regulators reckon that, even in a crisis such as the one that struck in 2008, banks’ cash on hand would always be good, or they could sell off Treasuries to get more cash.
More speculative securities, such as private mortgage-backed securities, don’t count toward the requirement, on the understanding that they could easily become hot potatoes in a crisis, assets that the banks would struggle to find buyers for except at fire-sale prices.
As a result, the rule “creates a regulatory demand” for banks to hold assets such as Treasuries, said Oliver Ireland, a senior counsel at the Morrison Foerster law firm who works on bank regulatory issues. Consequently, it bids up the price of Treasury securities, meaning that the federal government has to pay less to finance its debt.
But municipal bonds weren’t included in the definition of high-quality, liquid assets when the rule went into effect in 2015. Government officials soon realized that the rule thus created a disincentive for banks to buy municipal bonds, raising the cost of financing public works.
Since then, they and investors have lobbied regulators to change the rule to include municipal bonds. In 2016, they saw some success when the Federal Reserve decided to count investment-grade municipal securities in that category.
But the Crapo bill would go much further, forcing not just the Fed but also the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation to make municipal bonds satisfy the rule.
That is what states, counties, and cities have been lobbying for.
“Any motivation that would give the banks incentive to hold municipal securities is really all that we’re asking for,” said Emily Brock, director and federal liaison for the Government Financial Officers Association.
“Given the importance of municipal bonds to our communities – they are the life-blood of infrastructure development across the country – ensuring this debt remains attractive and low-cost is a priority for the nation’s counties,” said Fred Wong, communications director for the National Association of Counties.
State and local governments issue a lot of debt — nearly $450 billion worth in 2017, according to the Securities Industry and Financial Markets Association.
Brock called the bonds the “power tool in the tool kit” for municipal government finances.
Yet, in the past few years, state and local governments have been struggling to protect that tool.
First came the post-crisis rules. The liquidity rule and others provided incentives for banks and other investors to buy Treasury securities rather than municipal securities.
Then, the Republican push to overhaul the tax code threatened the huge advantage for municipal securities: that interest on those bonds is exempt from taxation. At times during the tax reform debate, the idea of eliminating that tax preference — worth about $400 billion over the next 10 years before the tax cuts, according to the Treasury — was bandied about.
Cities and states dodged that bullet. But because the tax bill lowered tax rates, the tax-free advantage of municipal bonds is diminished, and they are less attractive than, for instance, Treasury bonds, said David Damschen, Utah’s state treasurer and senior vice president for the National Association of State Treasurers.
Now, state and local governments are poised for a win that would once again boost demand for their debt.
But it would come at the cost of financial stability, said J.W. Verret, who called the idea of classifying “munis” as liquid assets “a very bad idea.”
Verret, a scholar at the free-market Mercatus Center, said municipal bonds are not liquid the same way that Treasury securities are. Giving banks an incentive to buy them would raise the risk that those banks would one day face a cash crunch and be stuck with municipal bonds that they aren’t able to convert to cash.
“It’s like saying the assets of places like Illinois, Detroit, or Puerto Rico are just as safe as Treasury securities,” said Verret, who formerly served as chief economist for the House Financial Services Committee under Republicans. ”That’s simply not true.”
In effect, the government would be intervening in markets to make one product, municipal bonds, more attractive to banks than it otherwise would be.
That’s not to say that all experts share that view. For instance, Aaron Klein, the director of the Brookings Institution’s Center on Regulation and Markets and a former Treasury official, said he supported the change.
In a note on the legislation, Klein argued that some municipal securities are high-quality assets that are traded frequently, meaning they probably would find sellers in a moment of market distress. And the legislation wouldn’t put them on the same footing as cash or Treasuries. Instead, banks would have to hold more of such assets to meet the liquidity rule.
“In the context of a financial panic, a small town’s water system, or the state of Maryland’s dedicated toll revenue bond, is no more likely to be caught up in a financial maelstrom than, say a previously highly rated corporate debt,” Klein argued.
“You can debate about that, but I think you have some competing considerations,” said Ireland, referring to the debate over the true liquidity of munis. “One of which is that you want to be able to finance municipalities at reasonable rates.”
The idea is parity for municipal debt, Brock said. Under the rule as written, “the banks could hold Greece’s debt, but they couldn’t hold state of Florida bonds” and satisfy the rule, she pointed out.
The state and local representatives who favor the Crapo bill said there is no easy way to factor in how much they could save for their taxpayers or how much more they could build, if the change goes through.
The terms of any one bond sale hinge on any number of factors, Damschen said. But, he explained, it’s incumbent on him “to exert an abundance of effort to optimize those transactions, maximize demand” for Utah’s bonds.
Verret acknowledged that treasurers have that responsibility, but argued that states and cities should focus elsewhere in their budgets to free up funds. “They should be more responsible about their pensions, and don’t make promises they can’t keep,” he said. “That’s the best way to fund infrastructure.”
