The IMF just released part of the Global Financial Stability Report. Chapter 3 is entitled “Safe Assets: Financial System Cornerstone?” and it has a lot to chew on. The two major points we will focus on in this post is what the IMF has to say about the impact on collateral stemming from a.) widespread adoption of Central Credit Counterparties (CCPs) and b.) the the Basel III Liquidity Coverage Ratio (LCR).
The paper starts out by laying the groundwork for collateral shortages and the distortions that may create. “In the future, there will be rising demand for safe assets, but fewer of them will be available, increasing the price for safety in global markets” and later in the paper “The tightening market for safe assets can have considerable implications for global financial stability, including an uneven or disruptive pricing process for safety.”
“The potential move of standardized OTC derivatives contracts to central counterparties (CCPs) may spur demand for high-quality collateral. OTC derivative transactions are highly dependent on the use of collateral, with 80 percent of these including collateral agreements. In 2010, approximately 80 percent of collateral backing OTC derivatives transactions was in cash and an additional 17 percent was in government securities. The shift of a considerable number of OTC derivatives transactions to CCPs under proposed changes to OTC derivatives regulation will elevate collateral demand by between $100 billion and $200 billion for initial margin and guarantee funds, though some of this will offset current needs in the OTC market. The resulting lower ability to rehypothecate, or reuse, the collateral in additional repo contracts when it remains within a CCP’s default fund may intensify financial institutions’ need for collateral to meet desired aggregate funding volumes. Indeed, one CCP has already decided that high-grade corporate bonds will be accepted as initial margin for swap trades as a result of a shortage of high-quality assets.”
The IMF’s figure of $100 billion to $200 billion of extra collateral needed to support CCPs is lower than many estimates in the market (including Finadium’s estimate of $1 trillion from their March 2011 report “Central Credit Counterparties, Margin and the Challenge of Collateral Management” — the Finadium number grossed up for the impact of collateral velocity) and others as high as $2 trillion. We are not sure everyone is comparing apples to apples in these estimates. Suffice to say the numbers are high.
The real eye opener in the report was on the LCR. “For example, on the liquidity side, unless banks alter their liability structure to moderate their liquidity needs, the requirements of the new Basel III Liquidity Coverage Ratio (LCR) alone could further increase the demand for safe assets by some $2 trillion to $4 trillion worldwide…To fulfill the Basel III LCR requirements by end-2009, large G20 banks would have required approximately $2.2 trillion in additional liquid assets, at least partly in the form of sovereign debt assets, according to the 2010 Quantitative Impact Study (QIS) of the Basel Committee on Banking Supervision (BCBS,2010b) (Figure 3.4.1). An extrapolation for smaller G20 banks and non-G20 banks—not included in the QIS sample—shows that the potential need for qualifying liquid assets globally is in the range of $2 trillion to $4 trillion, equivalent to 15 percent to 30 percent of banks’ total current sovereign debt holdings.”
$2 trillion to $4 trillion in additional “safe assets”? That is a sincere amount of paper. It is understandable why the drumbeat of easing collateral requirements is getting louder and louder – not only on the LCR side, but for CCP eligibly collateral as well. Finadium’s March 2012 report “Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets” looked at the shift. We are not so sure that easing up on collateral is always such a great idea from a risk perspective, but it appears to be the path of least resistance right now.
Here is a link to the March 2012 Finadium paper “Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets”.
Here is a link to the March 2011 Finadium paper “Central Credit Counterparties, Margin and the Challenge of Collateral Management”.
Here is a link to Chapter 3 of the Global Financial Stability Report. Chapter 3 “Safe Assets: Financial System Cornerstone?”