Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets

Finadium
March 2012

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The possibility has emerged that banks could use corporate bonds and equities for a broad swath of their high-quality liquid assets under Basel III. This would be an enlargement of a paradigm shift in the nature of risk in financial markets. Currently, Basel III requires that banks must have at least 60% of Level 1 assets, including cash and government bonds, and up to 40% of Level 2 assets, including agencies and the highest rated corporate bonds, to meet a critical component of the Liquidity Coverage Ratio (LCR). But what happens if the definition of Level 2 is stretched to include more corporate bonds and a new category for equities? Further, what happens if the LCR is changed to accept a greater quantity of Level 2 assets, or if corporate bonds and equities were to receive different risk-weightings for capital calculations?

This report looks at the possibility of change to Basel III recommendations and national capital regulations, some of which are already under active consideration, and the implications that this shift would have on bank balance sheets, collateral management and risk waterfalls. It also considers independent actions being taken by Central Counterparties in an attempt to make posting margin less difficult for their clients.

The acceptance of corporate bonds and equities would mark a significant change in the nature of risk and presumably risk-free instruments in financial markets. As government bonds become suspect as a consistent and reliable asset class, can corporate bonds with less than an AA rating and a broad swath of equities come in to take their place?

This report should be read by market professionals in liquidity and balance sheet management, and in repo, securities lending, OTC derivatives and other products that rely on cash and non-cash collateral.

This report is 28 pages with 11 exhibits.

TABLE OF CONTENTS
■ Executive Summary

■ One Step Back from the Brink
– What Would Actually Change in Basel III

■ The Impact on Bank Balance Sheets
– What Banks Need vs. What They Have

■ CCPs and the Risk Waterfall
– Assessing the CME’s New Acceptance Criteria
– Managing CCP Liquidity Risk

■ Broader Impacts in Financial Markets
– The Collateral Upgrade Trade

■ About the Author

■ About Finadium