STOCK MARKET WATCH -- Monday, 16 September 2013

[Demeter]

56. BIS Debunks Claims of Global Collateral Shortage

IMAGINE A STARVING BEAST, SALIVA SLATHERING OVER ITS PROMINENT CANINES...

http://blogs.wsj.com/moneybeat/2013/09/15/bis-debunks-claims-of-global-collateral-shortage/



The Bank for International Settlements on Sunday poured cold water on one of the financial sector’s most common complaints since the financial crisis: that increasing regulation and central bank bond-buying have drained global markets of the high-quality collateral. In an article in the BIS’s quarterly report, economists Ingo Fender and Ulf Lewrick argue that there is plenty to go around, although they do admit that it is unevenly distributed, and they warn that the financial sector’s new preference for secured lending–born out of the mutual mistrust that took root after the collapse of Lehman Brothers in 2008–may create whole new risks of its own.

Access to collateral matters because it’s far cheaper for banks to raise short-term funding to carry out their daily business if they can pledge something reliable as security. For smaller and weaker banks, there often isn’t any alternative. But with the U.S. Federal Reserve taking tens of billions of dollars of high-quality bonds out of the system every month with its quantitative easing program, and with a host of new regulations forcing banks to hoard more and more “high-quality liquid assets,” good collateral has been increasingly difficult to get hold of–at least for some.

Two regulatory initiatives since 2008 in particular have created what will be a structural shift in the demand for high-quality liquid assets: the Basel III Liquidity Coverage Ratio, which will force banks to make sure they have enough HQLA on their books to cover all their theoretical outflows over a 30-day period (aimed at making them proof against Lehman-like market shocks), and the requirement that as much as possible of the world’s trade in derivatives be underpinned by collateral. The authors estimate that, overall, demand for HQLA will rise by around $4 trillion to meet these and other regulatory and market challenges, albeit the LCR, which accounts for over half of that, will only come into full effect at the start of 2019. That sounds like a lot, until you consider how the supply of HQLA is developing. The authors say the market capitalization of benchmark bond indexes based on AAA-rated or AA-rated debt increased by $10.8 trillion between 2007 and 2012 alone. Nor are the bond-buying programs of central banks such as the Fed any drag on this, because although they take bonds out of the market, they inject central bank reserves, aka cash, the ultimate liquid asset, in return.

Admittedly, about $4 trillion of what has been created in the four years to 2012 has been stashed away in the foreign reserves of central banks, only some of whom have the freedom to lend those assets out to private-sector market participants. And the Financial Stability Board, which coordinates the global regulatory response to the 2007-2008 crisis on behalf of the Group of 20 largest advanced and emerging economies, has just announced plans that will make it harder to squeeze the maximum value out of such collateral that is freely tradable by the process of rehypothecation, in which the same collateral ends up underpinning a whole series of deals. The FSB this month recommended applying minimum “haircuts,” or valuation discounts, to collateral on such “repo” deals, making it prohibitively expensive to form long collateral chains. So there are plenty of constraints on getting collateral from actors who have plenty, to those who don’t have enough. A common problem, especially in the euro zone, where fears of unexploded bombs on bank balance sheets are still widespread, is that banks and funds with surplus cash (in countries such as Germany) are only willing to lend so much of it against paper issued by countries such as Italy or Spain, or by their banks, which have such high exposure to their respective sovereigns. It’s for that reason that the banking systems of Spain and Italy still have nearly 500 billion euros ($665.1 billion) in loans from the European Central Bank, an institution that is supposed to be the lender of last resort. The BIS as an institution is too respectful of protocol to spell out such issues too bluntly. But when the authors discuss changes to the structure of the funding market, they do note that “whether and to what degree such developments are lasting, rather than purely cyclical, depends on a variety of factors, including the success of sovereigns and banks in improving their creditworthiness.”

Or to put it in plain English, we wouldn’t be hearing so much about the global collateral shortage if banks were genuinely strong enough to be trusted by their peers, or if the bonds that are piled high on their balance sheets weren’t issued by countries that appear to the skeptical eye to be headed for bankruptcy.