There are risks in Basel III endgame's treatment of municipal bonds

BY SourceMedia | MUNICIPAL | 11/30/23 12:54 PM EST By Justin Underwood

The suggested treatment of municipal securities as posted collateral in the Basel III endgame proposal has garnered mixed reactions from experts and market participants. While some argue that it could enhance liquidity and stability in the market, others express concerns about the potential risks and challenges associated with valuing and monitoring these securities.

It is crucial for regulators to carefully assess the potential impact of this proposal on the overall financial system before implementing any changes. This proposal has sparked significant discussion and debate within the financial industry, and it is essential to weigh the potential concerns and implications of this treatment while considering alternative solutions or modifications.

The Basel III endgame proposal says municipal securities should be treated as posted collateral. This is based on how liquid and risky the securities are. Under the proposed framework, municipal securities would be subject to specific haircuts and eligibility criteria when used as collateral for financial transactions.

The goal of this treatment is to make sure that using municipal securities as collateral accurately reflects their liquidity and risk profile. It is in line with the larger goal of reducing systemic risk and promoting financial stability. However, the proposed treatment of municipal securities as posted collateral presents several potential concerns and implications that must be carefully considered.

One primary concern is the potential impact on market liquidity and the cost of financing for municipalities. The proposal could make it more expensive for market participants to use municipal securities as collateral by putting in place specific haircuts and eligibility criteria. This would make municipals a less appealing way for banks to get money.

The proposed rule makes it a potentially cost prohibitive business by increasing the cost of capital ? from 8% to 20% ? needed to hold it on their books.

This, in turn, may limit the ability of municipalities to access affordable financing, constraining their ability to fund essential infrastructure projects and public services.

Furthermore, the proposed treatment of municipal securities as posted collateral raises concerns about the broader implications for the municipal bond market. Municipal securities have traditionally been regarded as a relatively safe and low-risk asset class, reflecting the creditworthiness of the issuers and the essential nature of the projects they finance. There might be a mismatch between the real risk of municipal securities and how they are treated as collateral if strict haircuts and eligibility criteria are put in place.

This could distort market dynamics and lead to unintended consequences for investors and issuers, including reduced demand for municipal securities and potential volatility in pricing.

With these concerns in mind, it is important to think about other options or changes to the way that municipal securities could be treated as posted collateral.

One possible change would be to use a more nuanced approach to figure out the risk and liquidity of municipal securities, taking into account their unique features and the fact that the municipal bond market is very diverse.

As part of this plan, a custom framework could be made to evaluate the creditworthiness and marketability of municipal securities. This would make sure that their use as collateral is more in line with their real risk profile.

As an alternative, certain regulatory provisions could be put in place to protect the use of municipal securities as collateral without making them too hard to get or too expensive.

This could include the establishment of clear guidelines and safeguards to prevent excessive haircuts and eligibility criteria that could impede market liquidity and financing for municipalities. These rules could help protect the important role that municipal securities play in funding important public services and infrastructure by finding a balance between lowering risk and keeping the market running smoothly.

Ultimately, it is essential to recognize the unique role of municipal securities in facilitating infrastructure investment and supporting the operational needs of local governments. Any treatment of municipal securities as posted collateral must carefully consider the potential impact on market liquidity, financing costs for municipalities, and the broader functioning of the municipal bond market.

By looking into other options or changes to the proposed treatment, policymakers can try to create a fair regulatory framework that supports financial stability and recognizes the important role that municipal securities play in boosting economic growth and meeting the needs of communities across the country.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

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