(Recasts and broadens lead, adds information Treasury review)
By Pete Schroeder
WASHINGTON, Dec 4 (Reuters) - In a potential win for the banking industry, two top U.S. regulators on Wednesday signaled they may be open to changing supervisory practices that may have contributed towards disruption in the overnight lending markets.
Testifying before the House of Representatives Financial Services Committee, Federal Reserve Vice Chair Randal Quarles said the central bank is reviewing its supervisory practices in the wake of a September liquidity crunch in the "repo" market.
The smooth functioning of those overnight markets, which banks rely on to obtain short-term cash to finance trading and lending activities, is critical to the financial system. Banks offer up high-quality securities as collateral to obtain that cash, usually overnight.
Also on Wednesday, a U.S. Treasury Department-led regulatory panel charged with monitoring financial risks will formally recommend watchdogs review causes of the problems and whether they could pose risks to the overall system, according to a Treasury official.
Elements of the way the Fed enforces bank liquidity rules, including requiring lenders to hold large amounts of cash on hand, possibly discouraged banks from participating in the repo market, regulators have said.
"We have identified some areas where our existing supervision of the regulatory framework ... may have created some incentives that were contributors," Quarles told lawmakers. "They were probably not the decisive contributors, but they were contributors, and I think we need to examine them."
Specifically, Quarles said that liquidity stress tests that Fed supervisors run on large banks may have caused lenders to prefer to hold reserves at the central bank as opposed to other high-quality liquid assets like Treasury bonds.
Rates in the repo market suddenly spiked to 10% this fall, forcing the Fed to provide liquidity for the first time since the global financial crisis more than a decade ago. That support is still ongoing.
Reuters has previously reported that Wall Street banks believed Fed supervisors were nudging them towards holding more Treasury debt, which is a common type of collateral pledged by companies and investors in exchange for cash in overnight lending markets.
Before borrowing rates spiked in the repo market, banks had previously believed Fed supervisors preferred excess reserves were the preferred form for high-quality liquid assets that large banks must hold on their books.
Since September's crunch, bank lobby groups have been pushing the Fed to review liquidity rules and how the central bank enforces them.
"Some banks ... have put a heavy emphasis on central bank reserves as the most liquid assets," Quarles told the panel. "That does create a thumb on the scale."
But while Quarles signaled the way the Fed enforces its liquidity rules were being reviewed, he did not indicate that the Fed was rethinking the letter of the rules themselves. (Reporting by Pete SchroederEditing by Chizu Nomiyama, Paul Simao, Michelle Price and Cynthia Osterman)