Banking & Finance

Wanted: Liquid assets for collateral optimisation

27 Apr 2016

4 min read

In December 2012, EU leaders agreed to postpone the implementation of new banking regulatory capital measures under Basel III, potentially to the end of 2013 or January 2014. This has allowed regulators and bankers alike, across Europe, to breathe a
collective sigh of relief, albeit a short one.

Briefly, Basel III is aimed at rectifying certain deficiencies of previous iterations of the Accord which were seen as failings in regulating banking capital during the financial crisis.

One measure taken to assure the availability of high-quality liquid capital was to tighten the definition of “liquid assets”. Another measure was the introduction of two new liquidity metrics (the Net Stable Funding Ratio, and the Liquidity Cover Ratio), to encourage banks to take on longer term funding positions, rather than cheaper, short-term funding arrangements, which render credit institutions susceptible to runs on deposits. In addition, a countercyclical “liquidity buffer” has also been introduced and will be fully implemented by 2018.

Banks are required to hold enough liquid assets to meet these objective criteria, however, due to the reclassification of “liquid assets”, as well as the illiquid nature of certain assets – typically certain securitised products such as Mortgage-Backed
Securities (MBSs) and Asset-Backed Securities (ABSs) – many European banks faced situations where they were becoming unable to meet these requirements, most infamously Northern Rock (now Virgin Money).

A number of banks had to be “bailed-in” particularly the Spanish system which was bailed out last year to the tune of €100 billion, following failures in stress tests carried out by the European Banking Authority (EBA). An important source of bank liquidity in recent years has been Long Term Repurchase Operations (LTROs) run by the European Central Bank (ECB) and the Bank of England (BoE). These LTROs allow retail or commercial banks to borrow money at cheap rates from the ECB or BoE secured against eligible collateral. However, due to the heavy haircuts and poor ratings applied to the aforementioned MBSs and ABSs as collateral, some banks holding such assets have been unable to access the LTROs at a reasonable cost.

While this has posed problems for such banks it has, however, provided an investment opportunity for insurers and pension funds, particularly in the UK in the shape of Collateral Upgrade Transactions (CUTs) or Liquidity Swaps – indeed, in 2012, the
UK Financial Services Authority tried, but failed, to regulate these transactions.

The premise is as follows: Insurers and pension funds, due to the nature of their business and asset-liability management programmes, tend to hold highly rated, low credit risk instruments such as government debt, which are also highly liquid due to
the deep market and large demand for these instruments. The high liquidity of these instruments is incidental to their ALM programmes, but is not a criterion for buying them.

In recent years, yields on government debt have hit historic lows, such that insurers and pension funds have sought ways in which to enhance the yield on their portfolios. As a result, such investors would enter into CUTs or liquidity swaps with troubled
banks, whereby the former would “lend” the liquid assets to the latter, which loan is over-collateralised against the lower rated collateral (MBSs and ABSs). With their “borrowed” assets, the banks would be able to access the LTROs at a far more costefficient entry point, or simply lower their overall asset-risk exposure, while the insurers and pension funds would receive a manufactured payment for the use of their assets and, in the process, enhance their portfolio yield, while simultaneously being covered from potential credit risk through their collateralised position.

The main reason that a bank would undertake such a transaction is to access long-term secured funding opportunities, which, particularly, in the light of the new liquidity measures prescribed under Basel III, has become of some importance. It is,
therefore, prudent for financial and credit institutions to diversify their sources of funding and capital – for example, cash deposits currently provide little or negative returns for the risk, making them unattractive, especially in the context of Malta’s
traditional funding model. Banks may also seek to tap non-traditional sources of liquidity, such as pension funds and insurers, which typically sit on massive pools of government issued and highly rated securities (a report published by the MFSA in April

The risk transfer space in Malta is somewhat underdeveloped and, as a result, there is very little flow of inter-sectoral capital. However, the advent of the “age of regulatory capital” might see the financial institutions in Malta shed their traditional models and engage in collateral optimisation in the face of these new challenges.