Basel III LCR rules may change, allowing corporates and equities. Nestle debt looks a whole lot better than Portugal.

The irony of sovereign debt being used for Basel III Liquidity Coverage Ratios (LCR) yet becoming more risky by the hour from a credit perspective is coming home to roost. Word from the Basel Committee on Banking Supervision is that they may allow more corporate debt and equities to be (presumably) included in Level 2 of the LCR calculation. A Dec. 6th article in Bloomberg Business Week by authors Liam Vaughan and Gavin Finch note that large European banks, in response to the sovereign debt crisis, have been reducing their Euro sovereign debt holdings, making it harder for them to satisfy the LCR requirements.

The regulators may even change the practice of applying zero risk-weightings to home currency government paper. We note that Dexia is said to have looked to be in good shape prior to their collapse because they could risk weight some dodgy paper at zero.

The inclusion of equities could have a profound impact on the markets, underpinning demand for these assets. (Any hedge funds listening?) Listed equities, in particular, have long lived a double life as collateral: as a call on residual cash flow, they are volatile and less creditworthy than debt. But at the same time equity markets are often more liquid and price information more transparent than their OTC debt brethren.

The article also noted that European banks have a much higher portion of their assets in risk-weighted assets than American banks. This reflects the difference in how government debt is financed on both sides of the pond: European banks are much more likely to own government debt than American banks. What seemed like a good idea at the time, encouraged by favorable Basel III rules, has now soured. It is reminiscent of the capital arbitrage between banks owning mortgage assets outright vs. securitized mortgage assets during the sub-prime crisis and we know how that ended.

As an aside, we wonder if paper acceptable for LCR is changing to allow corporates and equities, could the CCPs be far behind?

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