The Regulatory Spillover Effects of Classifying Municipal Bonds as High-Quality Liquid Assets

Abstract

Basel III introduced one of the first global banking liquidity requirements: the liquidity coverage ratio (LCR). This paper examines if changing the regulatory accounting for the LCR by including certain municipal bonds in its computation has a spillover effect on the municipal bond market. In contrast to statements made by regulators, I find that the rule decreases the affected bonds’ yield spread, relative to unaffected bonds, due to an increase in bank demand for the affected bonds. Importantly, I am unable to find evidence that this change in the yield spread is due to a change in risk. Consistent with a decrease in yields, I document that municipalities that have the ability to issue either affected or unaffected bonds change their behavior by issuing relatively more of the affected bonds in the aftermath of the rule change. These results provide evidence that regulatory change in one sector of the economy can have a significant spillover effect on another sector of the economy which is not the intended target of the rule.