Insurers must beware a cash drought

The pressure on firms to optimise their collateral management is set to grow and traditional means of accessing cash when required might yet prove unreliable

For a while the financial community has talked of how the regulation of derivatives markets will transform credit risk into liquidity risk, requiring firms to collateralise trades with cash or highly liquid securities without much thought for the availability of such assets in a crisis. While few question the logic of pushing more products into central clearing, there is a growing sense among insurers that the pressure to source collateral could become a meaningful problem in future.

A handful of firms are starting to model liquidity risk quantitatively and consider the collateral requirements they would face in a variety of market shocks. These more advanced firms are working with banks to hedge against an intensification of collateral needs, which would be most likely in a rates-up scenario. But others seem reticent about the risk.

Many firms feel they hold plenty of high-quality assets that can be swapped easily for cash in the repo market. And most are assuming the repo market will be open to them to execute such transactions if they need. However, their view is somewhat out of step with that of the banks, which see pressures already on repo – due to the regulatory constraints that banks themselves face.

Cash is increasingly precious to banks. And they will have to be more selective in future about to whom and in what circumstances they make it available. 

Some suggest that sourcing collateral will become prohibitively expensive so that insurers will be forced to abandon the use of derivatives altogether. Such an outcome might be avoided, they argue, if policy-makers softened their approach – perhaps with an exemption from the Basel III leverage ratio for segments of the repo market. A radical option would be to provide access to central bank liquidity for insurers and pension funds.

Such considerations seem a long way off, however. All parties are agreed: there will be no easing of the rules until, as one London banker puts it, insurers start to “feel the pain”. In the meantime, insurers will need to begin thinking about collateral optimisation. Our coverage in November will include Insurance Risk’s third annual collateral management survey in collaboration with BNY Mellon, the results of which promise further insight into how firms are addressing these challenges.