The saga continues: what should Level 1 assets be in Basel III

Ah, the definition of Basel III Level 1 assets continues to befuddle, complex and give rise to all sorts of shenanigans. In today’s edition of the ongoing soap opera, Reuters reports that the European Covered Bond Association has been lobbying the governments of Singapore and Hong Kong to accept covered bonds as Level 1 assets in their upcoming roll-outs of Basel III. We’re taking the opportunity to comment on the state of Basel III Level 1 assets in general, which isn’t pretty.

Back in December 2011, word leaked that the Basel Committee on Banking Supervision was thinking that its current Level 1 definition, which emphasized sovereign bonds, was maybe too strict. Was a Greek bond really a better credit risk than IBM corporate debt? Probably not. Then in March 2012, the CME started accepting corporate bonds after much planning, sparking a sharp conversation about risk management and the notion that assets should be able to be liquidated in 59 minutes or less.

Also in March 2012, we released a big report on accepting corporate bonds and equities as High Quality Liquid Assets under Basel III. Here are a few clips from what we said then:

– “If the risk-weightings of corporate bonds and equities were to improve, that would immediately reduce the need for banks to raise capital to meet Common Equity Tier (CET) 1 ratios. Since CET 1 is a function of certain asset types over risk-weighted assets, this action would decrease the denominator of the equation, which in turn would make CET ratios higher.”

– “The LCR would also see a direct impact from improving the view and corporate bonds and equities. MBS assets are currently accepted as Level 2 with a 15% haircut but only up to 40% of a bank’s total numerator for its LCR. Adding in other securities including corporate bonds and equities, and excluding derivatives with a positive value, yields another US$502 billion for a total of US$1.354 trillion.”

“European banks are looking to sell off low quality assets in order to raise their CET 1 figures; changing the risk-weightings on those assets would reduce the pressure.”

The European Covered Bond Association has taken exactly the tack that we would have expected from a lobbying group. If MBS are accepted as a high quality asset eligible for Level 1 calculations, that would increase demand for these assets. The demand could be substantial, especially in jurisdictions like Singapore and Hong Kong that otherwise have a shortage of Level 1 assets. According to Reuters, “across the whole industry, the Basel Committee estimates that there will be a shortfall of up to US$3trn of the liquid assets required to meet liquidity coverage and net stable funding ratios. Some jurisdictions have argued that an open line of credit to the central bank will suffice as a substitute for enough liquid government debt.”

But in a brilliant move, the issuers of MBS have come striking back. Again according to Reuters: “But issuers of highly liquid covered bonds, such as the Nordic banks, are nudging regulators around the world and suggesting that their covered bonds could be used instead. The lobbying took an official turn in the first week of October, when the European Covered Bond Council (ECBC) published a position paper arguing that Nordic covered bonds met all the criteria required to be level 1 liquid assets so regulators should consider them as such.”

In truth, all of this back and forth gives strong support to the arguments of US Senators Brown and Vitter, the Bank of England’s Andy Haldane and others for scrapping the complications of Basel III in favor of more straight-forward capital and leverage figures.

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