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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
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
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
"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
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
"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.
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."
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)