«Committee on the Global Financial System CGFS Papers No 49 Asset encumbrance, financial reform and the demand for collateral assets Report submitted ...»
Committee on the Global
Asset encumbrance, financial
reform and the demand for
Report submitted by a Working Group established by
the Committee on the Global Financial System
The Group was chaired by Aerdt Houben, Netherlands
JEL Classification: G21, G28, G32
This publication is available on the BIS website (www.bis.org).
© Bank for International Settlements 2013. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.
ISBN 92-9131-935-X (print) ISBN 92-9197-935-X (online) Preface Given that the demand for collateral assets is increasing, the Committee on the Global Financial System (CGFS) in May 2012 established a Working Group (chaired by Aerdt Houben, Netherlands Bank) to explore the implications of this trend for markets and policy. This report presents the Group’s findings from a system-wide perspective and draws broad conclusions for policymakers.
The report presents evidence of increased reliance by banks on collateralised funding markets in recent years for some regions, with the increase being most pronounced in Europe. Regulatory reforms and the shift towards central clearing of derivatives transactions will also add to the demand for collateral assets. But there is no evidence or expectation of any lasting or widespread scarcity of such assets in global financial markets. Temporary supply-demand imbalances, however, may arise in some cases, as the supply of collateral assets varies widely across jurisdictions and institutions.
Endogenous private sector responses, such as collateral transformation activities, will help to address these supply-demand imbalances if and when they emerge. While this will mitigate collateral scarcity, these activities are likely to come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks. Hence, monitoring these developments and designing measures that limit any resulting adverse market implications for financial market stability should be an important focus of policy.
The concepts and policy implications described in this report are a timely contribution on an important topic. I hope that they will inform ongoing discussions among policymakers on some of the key issues related to increased demand for collateral assets.
William C Dudley Chairman, Committee on the Global Financial System President, Federal Reserve Bank of New York iii CGFS – Asset encumbrance, financial reform and the demand for collateral assets Contents Preface
2. Bank funding and asset encumbrance
2.1 Factors influencing the share of collateralised funding
2.2 Bank funding patterns in different banking systems
2.3 Asset encumbrance patterns
3. Demand for high-quality assets
3.1 Liquidity coverage ratio
3.2 OTC derivatives reforms
3.3 Demand from the official sector
4. Supply of high-quality assets
4.1 Exogenous supply factors
4.2 Endogenous market responses
5. Implications for the financial system
5.1 Risks from rising levels of asset encumbrance
5.2 Risks from increased collateralisation
6. Implications for policy
6.1 Transparency and disclosure requirements
6.2 Building prudential safeguards
6.3 Implications for central banks
Annex 1 Working Group mandate
Annex 2 Analytical framework: secured funding and asset encumbrance................. 37 Annex 3 Summary of the Working Group’s analysis of bank funding data............... 41 Members of the Working Group
The use of collateral in financial transactions has risen in many jurisdictions in the aftermath of the financial crisis, and is likely to increase further. This is driven by both market forces and regulatory changes, and has triggered concerns about real or perceived collateral scarcity and excessive asset encumbrance. Taking a systemwide perspective, this report examines how greater collateral use and asset encumbrance may impact the functioning of the financial system and draws lessons for policymakers. The key findings are summarised below.
Increasing collateralised funding and asset encumbrance
There is evidence of increasing bank reliance on collateralised market funding, particularly in Europe. A key driver of this development is perceptions of higher counterparty credit risk amongst investors, who demand more collateral or charge higher risk premia on unsecured debt.
However, the share of collateralised funding differs significantly among banks and between jurisdictions. Indeed, different business models, market structures and regulatory frameworks will tend to generate – and support – structurally different levels of collateralised funding in bank balance sheets.
Greater reliance on collateralised funding raises the share of bank assets that are encumbered. Asset encumbrance is also rising on account of initial margin requirements of central and bilateral counterparties to cover derivatives exposures and other aspects of regulatory reform.
No aggregate collateral shortages, but differences amongstjurisdictions
The demand for high-quality assets (HQA) that can be used as collateral will increase due to a number of key regulatory reforms. Examples are stricter standards for initial margin requirements on over-the-counter (OTC) derivatives transactions, both for central and for bilateral clearing arrangements, and the introduction of the liquidity coverage ratio under Basel III. This comes on top of greater demand for collateral assets in secured bank funding.
Current estimates suggest that the combined impact of liquidity regulation and OTC derivatives reforms could generate additional collateral demand to the tune of $4 trillion. At the same time, the supply of collateral assets is known to have risen significantly since end-2007. Outstanding amounts of AAA- and AArated government securities alone – based on the market capitalisation of widely used benchmark indices – increased by $10.8 trillion between 2007 and
2012. Other measures suggest even greater increases in supply.
Hence, concerns about an absolute shortage of HQA appear unjustified. Yet as the situation varies markedly across jurisdictions, temporary HQA shortages may arise in some countries, for example when the level of government bonds outstanding is low or when government bonds are perceived risky by market participants.
CGFS – Asset encumbrance, financial reform and the demand for collateral assets Implications for markets and financial stability Private sector adjustments can mitigate shortages of HQA. Such adjustments include broader eligibility criteria for collateral assets in private transactions, more efficient entity-level collateral management and increased collateral reuse and collateral transformation.
Yet while lessening any collateral shortage, such endogenous responses will come at the cost of greater interconnectedness in the financial system, for example in the form of more securities lending or collateral transformation services. They may also increase concentration, if these responses rely on the services of only a small number of intermediaries, and will add to financial system opacity, including via shadow banking activities, and increase operational, funding and rollover risks.
Increased collateralisation of bank balance sheets mitigates counterparty credit risk, but adds to the procyclicality of the financial system. The channels through which this occurs, in times of financial stress, are the exclusion of certain assets from the pool of eligible collateral, higher haircuts on collateral assets, increased margin requirements on centrally cleared and non-centrally cleared derivatives trades and marking-to-market of bank assets in collateral pools.
Greater encumbrance of bank balance sheets can adversely affect the residual claims of unsecured creditors during bank resolution, increase risks to deposit insurance schemes and reduce the effectiveness of policies aimed at bail-in.
Given limited disclosures on encumbered assets, the ability of markets to accurately price unsecured debt can also be impaired.
Implications for policy
Market discipline can be enhanced by requiring banks to provide regular, standardised public disclosures on asset encumbrance. Transparency about the extent to which bank assets are encumbered or are available for encumbrance will allow unsecured creditors to better assess the risks they face. Such disclosures would include information on unencumbered assets relative to unsecured liabilities, on overcollateralisation levels, and on received collateral that can be rehypothecated. Development of such standards would benefit from outreach to market participants and could involve the reporting of lagged, average values to limit adverse dynamics in crisis periods. Supervisors, in turn, should receive more detailed and granular data, as required, including the amounts and types of unencumbered assets.
Including asset encumbrance in the pricing of deposit guarantee schemes deserves consideration in jurisdictions where encumbrance is of concern. Since depositors will not themselves factor in the risks posed by increased asset encumbrance – as their deposits are guaranteed – risk-sensitive deposit guarantee premia could serve to discipline banks. This would internalise the effect of asset encumbrance on residual risks for such schemes, as well as for the government as the ultimate safety net. Further analysis is needed to make this operational, taking into account differences in business models.
To internalise the risks of rising asset encumbrance, prudential limits can serve as a backstop to other policy measures, as practised in some jurisdictions. In cases where encumbrance could become a material concern, banks should be 2 CGFS – Asset encumbrance, financial reform and the demand for collateral assets asked to perform regular stress tests that evaluate encumbrance levels under adverse market conditions.
Central banks and prudential authorities need to closely monitor and oversee market responses to increased collateral demand and their effects on interconnectedness. This provides support for work on best practice standards in securities financing markets and for shadow banking activities more generally, as well as for supervisory reviews of financial institutions’ risk and collateral management arrangements.
Concerns over procyclical demand for collateral assets lend support to efforts targeting strict standards for collateral valuation practices and through-thecycle haircuts.
CGFS – Asset encumbrance, financial reform and the demand for collateral assets
1. Introduction The use of collateral in financial transactions has risen in many jurisdictions in the aftermath of the financial crisis, driven by both market forces and regulatory changes. Market participants have shown increased appetite for secured long-term bank bonds, such as covered bonds. Likewise, reliance on repo markets, as opposed to short-term unsecured lending, has risen for some regions such as the euro area or the United States. Many banks, especially in Europe, have become increasingly dependent on collateralised borrowing, leading to rising bank asset encumbrance levels. Adding to the demand for collateral assets will be more stringent collateralisation requirements, a key element of over-the-counter (OTC) derivatives markets reform, and the new Principles for Financial Market Infrastructures (PFMIs) issued jointly by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO). New liquidity regulation under Basel III will require banks to maintain larger buffers of highquality liquid assets (HQLA).1 Finally, European insurance firms are likely to add to the demand for high-quality assets (HQA), driven by the new capital requirements under Solvency II.
These developments have raised concerns about the implications of increased collateralisation of financial transactions and bank asset encumbrance for the functioning and stability of the financial system. Against this backdrop, in May 2012, the Committee on the Global Financial System (CGFS) set up a working group, under the Chairmanship of Aerdt Houben of the Netherlands Bank, with the mandate to: (i) engage in a stocktaking exercise, including consultations with market participants, to understand the factors contributing to the increased reliance on collateralised funding markets, and how this may affect asset encumbrance on banks’ balance sheets; (ii) to assess the effects of ongoing regulatory reform initiatives on collateral demand, and how these influence the supply of collateral assets; and (iii) to assess the system-wide implications of these developments for markets and policy.2 The report, which documents the findings of the Working Group, is organised as follows. Section 2 discusses the factors that influence the share of collateralised bank funding and then documents bank funding patterns in different jurisdictions.
Challenges that arise when measuring bank asset encumbrance levels are also highlighted. Section 3 provides an assessment of the structural demand for HQA from various regulatory reforms. Estimates of HQA supply and ways in which real or perceived shortages of HQA could be met through behavioural responses are presented in Section 4. Section 5 examines the implications for market functioning and financial stability, and those for policy are discussed in Section 6.
For the purposes of this report, collateral assets are discussed in the context of three overlapping definitions of increasing generality (see Box 1 in Section 3): high-quality liquid assets (HQLA); highquality assets (HQA); and collateral assets (CA).
See Annex 1 for the Working Group mandate; a list of Working Group members is attached at the end of the report.
CGFS – Asset encumbrance, financial reform and the demand for collateral assets