REFILE-Banks push for rule rethink as sovereign liquidity disappears

Fri Jul 15, 2011 7:33am EDT

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By Matthew Attwood

LONDON, July 15 (IFR) - The evaporation of liquidity in the sovereign bond market this week highlighted how vulnerable banks can be if they hold too much sovereign debt, leading some bankers to suggest that the Basel liquidity rules should be changed to reduce concentration risk.

They say that the week's events show that some sovereign paper is neither liquid nor risk-free and that banks should be freer to make their own decisions about what constitutes a liquid asset.

Their warning came as one of Basel's own committee said in a report this week that authorities should be closely monitoring the effect of regulatory policies which provide banks with strong incentives to hold large amounts of government securities.

As envisaged under Basel 3 rules to be phased in by 2015, 60% of banks' liquidity coverage ratio (LCR) must comprise cash or government debt - Level 1 assets - with the remainder given over to Level 2 assets, which can include riskier government debt, covered bonds and high-quality corporate transactions.

The LCR has been designed to ensure that a bank maintain an adequate level of unencumbered, high-quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors.

"The rules are a little over the top," said one FIG DCM head. "The regulators have a restricted view of what is liquid and market participants do know what liquidity is. You deal with it all the time as a banker but choice has been taken away from the banks."

On Monday yields on Italian 10-year bonds were marked above 6% for the first time since the country sought euro convergence in 1997, with liquidity completely disappearing in Spanish and Italian paper on Tuesday morning. Bid/offer spreads in Greek government debt reportedly reached 100bp as the situation worsened.

"I doubt there was a single market-maker in European government bonds who would have made a two-way price between 8.30am and 10.30am on Tuesday," said one analyst.

SELF-REGULATION

Opinion is divided on how far the rules should change, but market participants agree that not all government bonds should receive the same treatment.

"If you're a bank treasury and you can theoretically hold Greek government bonds with the same capital charge as Bunds, you're incentivised to do so to maximise your yield returns," said a FIG syndicate banker familiar with the sovereign market. "But the market, the rating agencies and your own internal risk management would hold you to account in terms of your risk and act as a break on you buying lots of riskier government paper."

Others would like to see greater freedom for banks in addition to a reappraisal of the idea that all government bonds are risk-free and liquid.

"From a credit quality perspective covered bonds can be better than sovereigns so I'd expect liquidity to start picking up there, for example," said one head of FIG DCM.

However, not all agree. "Covered bonds are not a panacea," said a senior banker with close contacts in the Basel Committee. "Even though they benefit from a large investor base, you still need market-makers to make markets. It's very technically driven so I'd be surprised if they were given a greater role."

One of the problem of the future rules is that it could compound the next crisis.

"It is better for banks to be able to act in a relatively nimble and free way rather than exposing them to concentration risk in one asset class," said the head of FIG DCM.

"The current setup is just preparing the ground for the next crisis so at the very least I would like to see banks diversifying into foreign sovereigns."

ANOTHER AGENDA

However, this would worsen the position of already distressed sovereign issuers and some in the market believe that there would be serious resistance at high levels to any move reducing the domestic market for government debt.

"Quite a few people are wondering if there is some other agenda," said the FIG DCM head quoted above. "Sovereigns really need their local banks to buy. There was always the cliché in Italy, 'You don't get sacked if you buy BTPs', but that might come home to roost before long.

"You've seen the Greek banks go down because of the way they're exposed to the sovereign but even if something is liquid it doesn't mean that it's worth liquidating. If a bank needs to liquidate its assets quickly there's not much point in it doing so if it's going to take a loss of 20 or 30 points."

He also sees a problem with the rules' requirement on currency diversification. While he accepts that an institution's liquidity needs may mean that it should hold assets denominated in a variety of currencies, as laid down by Basel, he takes issue with the following warning in the recent Q&A on liquidity from the committee: "Banks and Supervisors cannot assume that currencies will remain transferable and convertible in a stress event, even for currencies that in normal times are freely transferable and highly convertible."

"Saying the swap and FX markets are going to blow up is a little bit extreme given that they're not taking into accounts all sorts of other risks at the moment," he said. "As with asset types, they need to be less restrictive on currencies."

(Reporting Matthew Attwood, Editing by Helene Durand)

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