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

ABSTRACT Basel III introduced the first global banking liquidity requirement: the liquidity coverage ratio (LCR). This paper examines whether loosening 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 affected bonds’ yield spread, relative to unaffected bonds, due to an increase in nonfundamental bank demand for the affected bonds. The regulation also has a real effect on bond issuance: municipalities that can issue either affected or unaffected bonds change their behavior by issuing relatively more of the affected bonds. This suggests that regulatory accounting changes can affect the economic behavior of entities that are not even subject to the regulation. JEL Classifications: H74; G21; G28; M40.