Level 2 HQLA: Second-Class Liquidity or Overlooked Opportunity?
You might be saying, "Kevin, it's in the name, level TWO, why don't you sit this play out." But, the purpose of all the extra safeguards tied to these assets (compared to their Level 1 counterparts) is to level the playing field, handicap your score, make it a fair fight. Are these sports analogies doing anything for you? Before we get too far off track, let's dive in, and see if we can't hit a home run on why Level 2s are snubbed at the big banks and whether that should change.
First, a little LCR/HQLA background info:
Banks must hold enough HQLA (high quality liquid assets) to cover 100% of their calculated net stressed cash outflows
HQLA comes in three 'levels': 1) Cash, UST, Ginnies; 2a) US Agency backed; 2b) investment grade corporate debt, some equities, munis
LCR applies 'haircuts' by level (% of fair market value counted as HQLA): Level 1 = 100%, 2a = 85%, 2b = 50%. LCR also limits the total amount of 2a + 2b to 40% of total HQLA
This is what I mentioned before, the regulators have spelled out exactly how much liquidity value a given security has in their eyes. $100 of FNMA MBS is exactly the same as $85 of cash held at the Fed. So I argue that Level 2a/b shouldn't be shunned, a bank just needs to get paid in extra yield to make up for the additional $15 of FNMAs they need to hold to reach their target LCR ratio.
Am I sure Level 2s are being shunned?
It sure looks like it. Twelve of the largest American banks reported a combined total of $3.6 trillion in high-quality liquid assets at the end of 2024. Do you know how much of that was cash, US Treasuries, and Ginnies (maybe some foreign central bank debt)? Answer: $3.5 trillion. (Only $275 million of 2b!)
The graph below shows how the split between L1/2 has evolved over the years. The steady downfall of Level 2 from 23% of holdings down to 8%, with a slight 2022 pop thanks to the Cat3 banks whose holdings went up as fast as they came down the following year.
But why? Why are the L2 holdings so below the 40% LCR limit? Why is L2's % of total HQLA declining? Why are these big banks avoiding assets that are historically regarded as liquid assets and explicitly count toward the LCR? Let's look at the case.
Theory A: Public disclosure leads to herd mentality
When the LCR public disclosure requirement switch flipped, a big spotlight was shown on all of the liquidity skeletons these banks may have been hiding in the back of their call report closets. And if there's one thing bank CFOs and Treasurers hate more than anything, it's being an outlier. As soon as all this detail on liquid asset buffer holdings was disclosed, convergence began.
Even in the most sophisticated herds, there's still a cow that decides which direction the mad rush goes, and it's usually the cow in front. Since 2020, JP Morgan's HQLA portfolio has been 100% Level 1 securities.
Theory B: Yield juice not worth the squeeze
Most every action a bank makes is (or at least should be) based on mathematics. In this case, the formula is a combination of maximizing yield while controlling for liquidity value and other risk-based components (capital risk weight, duration, etc.). The Investment Portfolio Team's job is to manage the risk appropriately first and then find the bank some NII scraps where they can.
The graph below paints a fair picture that the premium may not be there in recent history to encourage these portfolios to hold Level 2. Interestingly enough, the year the Cat3 banks popped up in Level 2 holdings is the same year the excess returns were at historic lows. Did they get burned? Or is something else at hand?
Another option is that it's just cleaner (a.k.a. easier) to hold a liquidity portfolio solely for liquidity risk purposes and if that is the case then cash and US Treasuries are king. This approach would upset Milton Friedman, but in these perma-turbulent times, nobody gets fired for erring on conservatism. Also, the disconnect between the LCR haircuts and capital risk weights makes the 'cleaner' case even stronger, especially with Basel Endgame lurking in the DC shadows.
Theory C: Regulations say one thing, Examiners say another
The regulations are cut and dry, and every LCR-eligible asset has a haircut percentage and a risk weight (if using the standardized approach). Like I mentioned earlier this should be a mathematically driven strategy given a few simple risk-based assumptions/restrictions. Does the math really say to hold $0 of Level 2 assets? Or do the regulators examining the math say to hold $0 of Level 2? Are they using ambiguous pieces of the regulations to make holding Level 2 assets a burden to the team (I'm looking at you 'liquid and readily marketable'). Regulatory fingerprints are all over areas of Treasury that don't seem to vibe on the surface, my gut is telling me this is one of those.
So what?
The sheer size of this market makes even a tiny inefficiency or externality material. I pulled all US banks' Call Reports and these institutions hold $7 TRILLION in their investment portfolios, bps become $billions. That's 3 times as much as Canada's GDP. These inefficiencies may cause something as innocent as leaving a few bps on the table that would otherwise go to shareholders or it could lead to a government-mandated demand curve shift for the securities it issues to cover its spending deficit. Regardless, I see a market opportunity to bring Level 2 HQLA back into vogue and nudge us back onto the path of market efficiency.