Regulators should resist a one-size-fits-all approach and remember the biggest culprit: the Fed, whose quantitative easing (QE) programme has sucked trillions of collateral out of the market to be placed on its own balance sheet.
Collateralization has become a mantra for the post-global financial crisis world. Policymakers, regulators, bankers and investors are all looking to high-quality collateral, specifically US treasuries and German Bunds, to reduce credit risks in the financial system, cushion market shocks and lubricate the flow of credit from banks to the real economy.
Unsecured investors are, also, worried about the increasing burden being placed on collateral assets, specifically those on the balance sheets of banks to whom they have lent money.
Should a bank default on its unsecured debt obligations, unsecured creditors often rely on the liquidation of collateral such as treasuries and Bunds on the bank’s balance sheet to recover their investment, after secured investors have been paid back.
This concern has taken on a new significance in the era of government bail-in provisions, where unsecured creditors can be written down to zero in the event of bank failure.
The trend toward increasing use of secured funding markets among European bank adds to this worry, as collateral used to provide credit guarantees to take assets off the table, a process known as asset encumbrance.
While secured markets can substantially lower funding costs for the issuer, reliance on these instruments takes high-quality collateral off the table, and risks a vicious circle of increased risk sensitivity among unsecured creditors and potential death of unsecured funding.
International regulators and capital markets bodies have recently focused attention on this topic and have called for improved disclosure.
Moreover, some regulators are looking at the prospect of imposing limits on the level of assets that banks are permitted to encumber via secured funding operations. However, disclosure standards are far from ideal.
Although it’s possible to track covered bond issuance volumes in the public market, other secured funding markets, such as repo and securitization, are less visible.
A draft proposal from the European Banking Authority on asset encumbrance reporting is a step in the right direction, and the market is waiting for final implementation technical standards to emerge later this year.
In the meantime, economists from the Bank of England (BoE) and the University of Auckland have attempted to estimate the level of asset encumbrance in Europe at a national level.
According to a research paper seen by Euromoney Insight, encumbrance has increased by as much as 10 times during the past five years in some European countries. Unsurprisingly, the highest levels of encumbrance occur in countries that have suffered the worst effects of the sovereign debt contagion, such as Greece (37% of assets encumbered), Spain (24%), Ireland (18%) and Italy (12%).
The report indicates that covered bonds and central bank operations are the largest sources of encumbrance in Europe.
A market source familiar with the matter says in jurisdictions where banks tend to favor secured funding markets, such as Germany and the Nordic countries, levels of encumbrance will necessarily be higher. In view of the diversity of bank funding markets, regulators should be cautious about one-size-fits-all asset encumbrance rules.
“Encumbrance levels are dictated by business models and local custom,” says the source. “Any regulatory response needs to take account of these regional differences, different types of encumbrance and the funding flexibility of individual banks.”
While the encumbrance debate focuses on bank funding and micro-prudential regulatory concerns, there is a risk that regulators are missing the bigger, macro-prudential picture.
Although long-term debt instruments, such as covered bonds, can encumber assets for many years, typically two to 10 years, there is another source of asset encumbrance in the global financial system that nobody seems to be talking about.
The Federal Reserve’s QE programmes have taken some $2 trillion of US treasuries out of the market and encumbered them on its balance sheet, with the BoE absorbing another £500 billion or so. Notwithstanding the intricacies of QE tapering, it’s not clear how much of this asset base will return to circulation and when.
“People forget that when central banks do quantitative easing, they take good collateral out of the system, which is now sitting on a central bank balance sheet and not moving throughout the financial system,” says a Washington DC-based economist.
“Regulators who say there is too much encumbrance going on should look a bit closer at what is happening as a result of their own monetary policy.”