Today there was interesting article in the FT about how European banks, and in particular those under stress, manage collateral. While the context was primarily collateral to be pledged to the ECB, there was mention of CCPs and the collateral drain they will create. Never was there a better poster child of why collateral management will be front and center. Finadium’s March, 2011 report, Central Credit Counterparties, Margin and the Challenge of Collateral Management analyzed the issues up close. Here is a synopsis of the Finadium research report.
By Tracy Alloway
Just three months ago, Dexia announced it had €88bn ($121bn) of quality assets on its balance sheet. With the European Central Bank offering funding for the region’s troubled financials against such collateral, this sum should have been enough to stave off disaster at the Franco-Belgian bank.
Except for one problem: less than a quarter of that €88bn was actually free to be used as ECB collateral.
Some €68bn of the assets had been already tied up, or “encumbered”, in the bank’s various funding programmes, including tapping the ECB for extra money – a factor that helped precipitate Dexia’s move into government arms this month.
With more and more banks resorting to so-called “secured funding” – or financing that is backed by specific pools of a bank’s own collateral – concerns are rising over the growing levels of such asset encumbrance.
Or, put another way, whether Europe’s banks have enough free collateral to see them through the
crisis.
“The most sophisticated investors are definitely looking at asset encumbrance now,” says Marc Tempelman at Bank of America Merrill Lynch.
Unnerved by the eurozone debt crisis and uncertainty over forthcoming regulation, investors in, and lenders to, Europe’s banks have been demanding more and more collateral. This trend has been most obvious in public issuance of bank debt – where banks have this year sold about €200bn worth of covered bonds backed by their own pools of collateral. Banks are using other types of secured funding, too – for instance, borrowing money from other banks.
In the case of both covered bonds and private lending, deals are “over-collateralised”, meaning they are stuffed with extra assets to provide added security. Indeed, pressure to do more collateral-backed deals means an increasing proportion of a bank’s balance sheet may be tied up in secured financing.
While that may make the deals more palatable to a bank’s counterparties, it does little to help its unsecured creditors. In the event of a bankruptcy they will be left to pick over the bank’s assets that are not tied up in secured lending or covered debt.
There are limits in place to battle encumbrance. National regulators dictate how much of their balance sheets banks can encumber through covered bonds, though the rules vary.
Rating agencies, too, may start to downgrade the credit ratings of a bank’s senior unsecured debt if they feel assets are being dragged away by secured funding. Banks will also have internal guidelines, looking at how much of their balance sheet is encumbered.
Even so, some Spanish banks may be bumping up against those limits, according to Deutsche Bank covered bond specialist Bernd Volk. In other words, the banks may eventually run out of mortgages and loans to put into new covered bonds, or even to top up existing ones. To help, the ECB has announced two new longer-term refinancing operations, offering cheap loans against certain collateral. But that has sparked a debate about whether Europe’s most troubled banks will have enough eligible securities to make use of the system.
“Some banks might not have sufficient collateral to increase their ECB borrowings from current levels,” BofA interest rate strategist Ralf Preusser writes in a note to clients.
“The best examples are the Irish and the Greek banks,” which have been tapping their countries’ emergency liquidity assistance programmes, he says.
Still, other analysts believe most European banks have enough unencumbered collateral – or can create enough new securities – to weather the eurozone crisis.
“Even if your stock of eligible securities gets low, there are manoeuvres you can do to create more,” says Simon Adamson at CreditSights, citing the example of Greek banks issuing bonds guaranteed by Athens and used for borrowing from the ECB.
Yet, as regulators and market participants try to fortify the financial system, demanding more and more high-quality collateral to back up lending and even derivatives trades, the required pool of securities becomes ever greater and the amount available ever smaller.
Morgan Stanley estimates that more than $2,000bn of additional collateral will be required as derivatives move towards central clearing. Dexia is also said to have run down its collateral pool as its derivatives counterparties began demanding more pledged assets.
“Secured funding is part of the solution but it isn’t a panacea,” says Matthew Pass, head of bank debt at RBC Capital Markets. “We can’t all over-collateralise, it just doesn’t add up.”
Copyright The Financial Times Limited 2011.