Are there enough liquid assets to satisfy regulations?

Incoming rules will create demand for large quantities of liquid assets – principally government bonds – and will also require those assets to be locked away. It’s not clear there are enough bonds to go round, and nobody knows how the system will function when it’s less well lubricated. By Duncan Wood

If the financial system is a machine - a rumbling contraption of cogs, gears, belts, levers and dials - then liquid assets are the grease that keeps it running. Regulators are now putting the finishing touches to three different sets of rules that will force market participants to hold more liquid assets, possibly amounting to multiple trillions of dollars - but will also prevent this grease from being spread around the system.

The end result could be a smaller machine that is more expensive to run - an outcome policy-makers say is no bad thing given the devastation caused when the old system blew up. But critics - including debt offices, regulators and even some of those involved in drafting the rules, as well as the obligatory bankers - are worried about a rash of unintended consequences (see box).

Chief among them is the impact on the market for assets that are defined as liquid. At the moment, that means sovereign debt plus a small supporting cast of other highly rated bonds. The extra, guaranteed demand for these assets could send the wrong signals, driving down borrowing costs and enabling issuers to sustain higher debt levels.

"Supervisors have no interest in encouraging sovereign borrowing per se, but if we deem that sovereign debt is the highest-quality asset, then of course there is going to be an implicit subsidy, if you will, from prudential supervision to the government budget. It's impossible to avoid," says Lars Frisell, chief economist at Finansinspektionen, the Swedish financial regulator, in Stockholm.

Cynics claim this implicit subsidy - coming at a time when many governments have large deficits to finance - is far from unintentional. In particular, the UK - which is said by those working on the liquidity rules to be particularly keen on restricting the scope of eligible assets - is the subject of some sly digs. "In informal circles, we've all joked they just need to find a way to finance their debt," says a European regulator who sits on the working group charged with drawing up the liquidity rules.

That's an impression one senior UK regulator does little to dispel. "The creation of permanent demand potentially has the effect of enabling governments to run larger deficits than otherwise. But, you know, perhaps that's not entirely a bad thing given where we appear to be," he says.

Politicians may agree, but those charged with raising government money see it as a dangerous step. Speaking at a private meeting of OECD debt managers in early October, Thomas Olofsson, head of debt management at Sweden's Riksgälden, was sharply critical of the incoming liquidity rules in particular. "Governments need to face the market price on large debts. If you force the private sector to finance government debt, you take away incentives for the government to restrict the budget. In a well-functioning market economy, I think it's important to have market pricing so you can actually see how much it costs," he says.

He's not alone. The head of another European debt office - who was also present at the meeting - calls Olofsson's objections "extremely sensible" and reads approvingly from a presentation made by the Swede at the meeting: "As debt managers, we would perhaps be expected to approve of this, but experiences from Sweden in the 1980s and elsewhere show that a banking system stuffed with government debt does not give either functioning credit markets or incentives for fiscal responsibility, and it is not the task of financial regulation to alleviate sovereign debt problems."

The three regulations in question cover bank liquidity risk, derivatives market structure and capital standards for insurers - they're seeking to do very different things but each has a similar impact. First, under the Basel III framework, banks will be required to hold enough liquid assets to see them through a one-month period of stress - a rule known as the liquidity coverage ratio (LCR). Liquid assets are defined as cash, central bank reserves and highly rated government bonds. Amendments agreed in July would also allow some 40% of the buffer to be made up of ‘level 2' assets - defined as high-grade debt from non-government issuers plus bonds issued by less-creditworthy sovereigns - but a 15% haircut would be applied.

Second, new rules to compel parts of the over-the-counter derivatives to be cleared through central counterparties (CCPs) will result in large amounts of liquid assets being hoovered up in the form of initial margin. Finally, insurance companies may be encouraged under Solvency II, the incoming European capital adequacy regime, to back their annuity portfolios with government rather than corporate bonds.

In all three cases, more liquid assets will be needed - and it's not clear there are enough to go round. Policy-makers, though, say it's all under control. "It's difficult to say whether the supply of bonds will match the increased demand, but it's an important question - and it's fair to say there is a sort of coincidence of regulation that is all going in the same direction. To my mind, that's something policy-makers are aware of and will tackle where necessary by finding alternative ways to satisfy the various parameters," says Mauro Grande, director-general for financial stability at the European Central Bank in Frankfurt.

A senior UK regulator says much the same: "Of these three issues, two are the responsibility of people in this room, and the third is an extraneous source of demand that we clearly need to know about if we ourselves are also creating demand. So, regulators do talk about this."

But it's tough to find any evidence that the cumulative impact is being sized-up in a formal way. Even those close to the new rules are unaware of any quantitative studies to estimate the impact of the various incoming rules. "It's difficult enough to know what the impact of one strand would be - the one we actually have influence over. There has been some attempt to assess the impact of each of the various strands, but I'm not sure if anyone has looked at them all together," says a second regulator who sits on the LCR working group.

The impact of the rules depends on the amount of demand they generate, and there are almost no estimates publicly available. The Basel Committee on Banking Supervision conducted a quantitative impact study (QIS) during the first quarter of this year, which asked banks to take the draft Basel III proposals and work out how they would be affected if the rules were implemented immediately.

Unlike previous QIS exercises, the results haven't been published, but the European LCR working group member shares some of the numbers: if all 27 Basel Committee members had implemented the original rules, they would have needed $4.3 trillion in liquid assets to comply with the LCR. For eurozone members only, the total would have been $1.6 trillion - roughly 30% of the available stock of liquid assets, according to the committee's calculations. A later iteration of the LCR, which wasn't approved by the Basel Committee, would have dramatically reduced the requirements to $2.3 trillion and $900 billion for all committee members and for eurozone members, respectively.

The numbers have to be taken with a large pinch of salt, the regulator warns - there were a lot of assumptions and extrapolation required. The LCR has also continued to evolve, although the second set of figures is more likely to be indicative of the impact of the current rules, he says. The committee is currently engaged in a ‘mini-QIS' that will gather data on the latest version of the LCR in an attempt to resolve an impasse that has formed in the liquidity working group - principally over the scope of the liquid assets definition.

"There are two factions. One group argues the existing criteria are not harsh enough, while the other says ‘well, hang on, we could see some unwanted effects if we are too harsh. We could be too harsh right now and we need to rethink and open up, especially the stock of liquid assets discussion'," the regulator says.

It's just as difficult to find firm estimates on the demand OTC clearing will generate. Over the next couple of years, thousands of derivatives market participants are expected to load the majority of their portfolios on to CCPs, requiring many of them to post initial margin for the first time. But the demand will be spread across a slightly wider range of assets than that caused by the LCR - some clearing houses accept mutual funds and bank certificates of deposit, for example. In addition, margin requirements will depend on how much of the market is required to be cleared and the amount of netting that can be achieved - which, in turn, depends on the level of fragmentation in the CCP market and the extent to which netting can be achieved across products, national borders and between clearing houses.

As a result, any estimates require a host of assumptions to be made. In a paper published in April this year, Manmohan Singh, a senior economist at the International Monetary Fund in Washington, DC, assumes two-thirds of the OTC market will end up being cleared, consuming total initial margin of around $200 billion. That's some way below the $750 billion figure that is bandied about for rates products alone by members of SwapClear, says the head of clearing at one large bank. He stresses this figure is just to help frame discussions - but says it wouldn't be ridiculous to suggest total initial margin costs for the entire market could end up well above $1 trillion.

By comparison, the additional demand associated with Solvency II ought to be a drop in the ocean - tens of billions, rather than hundreds. Paul Barrett, assistant director for financial regulation at the Association of British Insurers in London, says it is too early to be able to predict with any certainty how insurers will be affected, as the Solvency II rules have not been finalised. However, some analysts have forecast that annuity writers will be forced to sell some of their corporate bonds in favour of less risky government bonds. Barrett declines to estimate the likely amount of rebalancing but it could be significant - annuity liabilities across Europe amount to around £250 billion, and roughly half are currently matched with corporate bond assets, he says.

In total, the three rules could comfortably generate demand for $3 trillion-4 trillion in liquid assets, and it's not impossible to imagine a bigger number, says Frank van Gansbeke, head of group liquidity regulatory affairs at BNP Paribas in Paris: "You're seeing a drag on high-end collateral from various sources that is all taking place concurrently. Even if banks change their underlying business strategy and/or their funding profile, these are still staggering numbers."

The market impact, though, ought to be staggered. Leaders of the Group of 20 nations want the switch to OTC clearing to be completed by the end of 2012 - although that's thought to be optimistic - and Solvency II should be implemented by the same date. The LCR, by contrast, won't become a hard requirement until 2015. Individual banks are already preparing, however: John Cummins, group treasurer at RBS in London, says the firm currently holds a government bond portfolio worth £25 billion as a liquidity buffer, which is forecast to grow to £50 billion by 2013.

It's the rate of this growth across the industry that will determine the impact on asset prices. To date, there's been little sign of banks preparing for the LCR by stocking up on government debt, says Laurent Fransolet, head of European fixed-income strategy at Barclays Capital in London. "If you overlay buying volumes with the shape of the yield curve, you can see that a lot of the volume - for example, in the first half of 2009 - was simply determined by the steepness of the curve. It was steep, so it was profitable to buy bonds and fund them overnight, but there's been very little activity that appears to be regulatory-driven buying," he says.

The Bank of England's foray into quantitative easing - which saw it acquire a total of £198.2 billion in gilts between March 2009 and January 2010 - is generally reckoned to have kept yields 75 basis points lower during that period, says Fransolet. If incoming regulations generate $1 trillion or more of additional demand for liquid assets, it has the potential to dwarf the impact of quantitative easing - but only if the buying is compressed into a relatively short time span and a narrow range of securities. It's more likely, he says, that the downward pressure on yields would amount to a few dozen basis points.

In addition, global issuance ought to accommodate the extra demand, says Fransolet. Barclays Capital estimates eurozone governments require roughly €900 billion in funding each year for the next three years, starting with €908.5 billion in 2011 and falling to €820.9 billion in 2013. Issuance in the US is expected to be somewhat higher, at around €1.4 trillion in 2011.

Unfortunately, it's not as simple as shepherding the new demand towards a handful of big issuers. Jurisdictions with large banking sectors relative to the amount of government debt they issue - such as Australia, Denmark, Hong Kong, Norway and South Africa - are already complaining they don't have enough liquid assets in their domestic market to comply with the LCR alone. Their banks could satisfy the rules by buying foreign assets instead, but policy-makers and regulators in these countries worry about adding more currency risk to the system, and protest it's not their job to help heavily indebted foreign governments sustain their deficits.

"There's an ethical, moral and political dimension. Some people are asking ‘why should we - as non-Americans, non-Brits - encourage our banks to finance government debt in the US and the UK?'," says the European regulator who sits on the LCR working group.

The countries that have objected so far tend to be those closest to the rule-making process, he notes. Other countries that could adopt the new rules may still be in the dark. "Even in Europe, there are a lot of countries that are not sitting at the table but will have huge problems with this. Take Hungary as an example, which is seeking to rein in borrowing. Its economy has had problems in the past with exposure to Swiss francs. If it is now forced to go and stock up on euro-denominated assets, is euro exposure going to be its next problem? These are problems we have to face up to," he says.

That's exactly what the LCR working group is now trying to do, the European regulator says. At the time the LCR was amended to include level 2 assets, the Basel Committee also signalled it would continue working to develop standards for jurisdictions that do not have enough level 1 assets - and the work goes on, with Australia and Hong Kong both pushing hard to be given more freedom. "They're very concerned and are putting in a lot of work to create standards that won't leave too many loopholes for others," he says.

For now, those watching the process are content to let it run its course in the expectation the rules will be adjusted. "I can see the problems this raises and there is some concern, but I don't share it. When it comes to countries where there aren't enough bonds, that's something the Basel Committee is working on and there will probably be more clarity when the final package is published in December. From a global perspective, I am not that worried," says Mattias Persson, head of financial stability at the Sveriges Riksbank, Sweden's central bank.

 

Reduction in rehypothecation blocking the system

In the pre-crisis years, liquid assets were made to work hard. They were lent out, sold, used to meet obligations or pledged to create liquidity. When they flowed in the front door via collateral posting, they were instantly shipped out of the back door via rehypothecation.

That model is coming to an end. Not only are clients preventing banks from rehypothecating assets, but incoming rules that require market participants to load-up on liquid securities will also force those assets to be locked down. Basel III says assets held in liquidity buffers need to be unencumbered and freely available to the group treasurer and to group entities in the event of a squeeze. Central counterparties also need their initial margin to be available instantly in case a member defaults.

That's going to change the way banks do business and affect the volume of assets flowing around the market, says Mark Penney, head of capital management for global markets at HSBC in London: "In our liquidity pool, we currently have a portion that we consider to be unavailable for trading - although we might switch between particular tranches or issues - but we also maintain some of the pool unencumbered in the trading book for general trading. It's certainly the case that, in future, the pool of locked-up assets will grow - and it will grow as a proportion of the total pool."

Not everyone is convinced that's a step forward. "Banks do a very good job of using and reusing collateral," says Manmohan Singh, a senior economist at the International Monetary Fund (IMF) in Washington, DC. "If you had a given volume of assets with the ability to churn them, it felt like a multiple of that in the market. But if all that gets parked somewhere and put in a silo, you're missing a lot of financial lubrication." Singh's research suggests that between the collapse of Lehman Brothers and the end of 2009, there had already been a $2.4 trillion drop in collateral that was available for rehypothecation at the biggest US banks.

Other powerful forces are also affecting the availability of grease in the financial system, such as the changed nature of bank funding markets, says Frank van Gansbeke, head of group liquidity regulatory affairs at BNP Paribas in Paris.

Counterparty concerns in funding markets have been tackled through a combination of central bank intervention and collateralised interbank market platforms, he notes. As of the end of September, four central banks - the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve - had outstanding tender and/or repurchased assets totalling $3.9 trillion, all of which is collateralised, says van Gansbeke. Assuming a 20% collateral haircut, that would suggest around $4.7 trillion in liquid assets is already tied up - and more collateral is committed to collateralised interbank market platforms such as those run by Eurex and e-MID in Europe, he says.

Compounding the problem, even banks that are healthy enough to borrow in the interbank markets may find they can no longer do so on an unsecured basis, says Mauro Grande, director-general for financial stability at the ECB in Frankfurt. "We would guess that banks will be less willing to engage in unsecured lending, which is a further force creating demand for high-quality assets. While we expect other segments of the market to rebound, unsecured lending may not," he says.

What does all this mean? One senior UK regulator cuts to the chase: "If you limit the amount of oil, the engine can only be so big."

To van Gansbeke at BNP Paribas, that means the system needs to generate more oil. "There is a real need for more collateral and more long-term financing, but there are a lot of assets on bank balance sheets that aren't being used and I'm a little taken aback the industry hasn't yet tried to relaunch and revitalise the securitisation market. It's tainted - for some good reasons - but the technique itself is sound and if it was combined with a proper code of conduct and a risk methodology that was set in stone and applied in proportion to the overall balance sheet, I think there's a partial, but valuable answer there for our collateral shortage provided investors are convinced of the improved asset nature," he says.

The ECB's Grande gives the idea a vote of support. "I would very much agree with the notion - the market is clearly blocked at the moment. If the industry can go back to the simplest forms of securitisation and successfully find ways to rebuild confidence in the product, it will help address concerns about whether there's enough collateral to satisfy regulatory requirements," he says.