Collateral scarcity and asset encumbrance: implications for the European financial system

Collateral scarcity and asset encumbrance: implications for the European financial system Aerdt Houben Director De Nederlandsche Bank, Financial Stability Department Jan Willem Slingenberg Economist De Nederlandsche Bank, Financial Stability Department In the financial sector, there is increasing demand for high quality collateral assets that combine liquidity with low credit risk. This is fuelled by greater risk aversion since the onset of the global financial crisis in 28 and by regulatory initiatives such as collateral requirements in derivatives markets and liquidity requirements for banks. In turn, increasing collateral use is boosting the share of encumbered assets on banks balance sheets. This may have adverse implications for the financial system. Collateral use adds to complexity, opacity and interconnectedness between financial market participants. Asset encumbrance also reduces the scope for bail in given less residual assets for unsecured creditors. Beyond this, increasing collateral use exacerbates procyclicality stemming from haircuts, margin requirements and collateral eligibility. Taking a European perspective, this article maps out the recent rise in collateral demand and asset encumbrance, investigates the implications and sketches policy options, including greater transparency, prudential limits, better guarantee pricing and tighter risk management practices. NB: The authors currently serve as chair and member, respectively, of a working group of the Committee on the Global Financial System (CGFS) that has been asked to analyse the implications of increased demand for collateral assets from a system wide perspective; inputs from individual working group members and stimulating discussions at the group level are gratefully acknowledged. The opinions expressed in this article remain those of the authors and do not necessarily reflect the views of De Nederlandsche Bank or the CGFS. Banque de France Financial Stability Review No. 17 April 213 197

Since the beginning of the global financial crisis in 28, counterparty credit risk has risen markedly in the banking sector. Natural responses are to demand higher risk premia or to request more collateral, which have both been observed in bank funding markets. Interest rate spreads in unsecured money markets have soared while unsecured interbank lending has collapsed. By contrast, volumes in the secured market for repurchase arrangements (repos) have increased substantially, reflecting a shift from unsecured to secured funding. Similar developments have been visible in long term bank funding markets, where issue volumes of long term unsecured bonds also fell significantly after the crisis, while total covered bond issues have been on the rise. In addition to increased risk aversion, the use of collateral in financial transactions and the demand for high quality liquid assets (HQLA) have also been spurred by regulatory initiatives. Examples are the introduction of collateral requirements for centralised and non centralised derivatives and the introduction of liquidity requirements under Basel III. Although risk aversion will abate as stress in financial markets declines, the increase of collateralisation and demand for HQLA due to new regulations are of a structural nature. Increased collateral use in financial transactions has important implications for the structure of the financial system. A greater scarcity of assets that can be used as collateral is likely to boost securities lending, collateral transformation and the shadow banking sector, and heighten interconnectedness within the financial system. Moreover, it will bring about a rise in the share of encumbered assets on banks' balance sheets. This adds to complexity and opacity in the financial system and reduces the scope for bail in. Furthermore, increasing asset encumbrance exacerbates procyclicality due to haircuts, margin requirements and collateral eligibility. The main message of this article is that policymakers should mitigate the negative implications of increased collateral use, while sustaining the regulatory initiatives geared at greater financial resilience. This can be done by increasing transparency requirements, setting maximum limits and pricing deposit guarantee schemes to reflect encumbrance of bank assets. These measures should be combined with a closer monitoring of market responses to asset encumbrance and collateral scarcity, and an upgrade of risk management practises to incorporate collateral provision and transformation. The remainder of this article is structured as follows. Section 1 sketches the increased use of collateral in financial transactions. Section 2 discusses the likelihood of collateral scarcity given higher risk aversion and ongoing regulatory reforms. Section 3 then describes the risks stemming from increased collateral use in financial transactions. Section 4 draws policy conclusions. 1 Increased use of collateral in financial transactions The use of collateral in financial transactions is on the rise. Driving factors behind this trend can be found both in funding and over the counter (OTC) derivatives markets. 1 1 Secured funding There is a rising trend of reliance of banks on collateralised market funding in Europe. The obvious cause for this is the financial and sovereign debt crisis in the euro area. Risk aversion has increased sharply due to concerns about the solvency of Chart 1 Covered bonds, outstanding in Europe (EUR billions) 3, 2,5 2, 1,5 1, 5 23 24 25 26 27 28 29 21 211 Germany France Others Spain United Kingdom Denmark Netherlands Source: European Covered Bond Council, DNB. 198 Banque de France Financial Stability Review No. 17 April 213

Chart 2 Average daily turnover in secured and unsecured cash lending (Index: 22 = 1) 24 22 2 18 16 14 12 1 8 6 4 23 24 25 26 27 28 29 21 211 212 Unsecured lending Secured lending Note: The panel comprised 15 credit institutions. Source: ECB. Chart 3 Central bank lending to euro area banks (EUR billions) 1,2 1, 8 6 4 2 25 26 27 28 29 21 211 212 Note: Excluding Emergency Liquidity Assitance (ELA). Source: ECB. European banks and the fiscal position of euro area countries. This has caused investors to demand more collateral or higher risk premia on unsecured debt. As a result, long term debt markets have shifted towards secured funding. Since 27, the amount of outstanding covered bond debt has increased significantly in all euro area countries except Germany, where legislative changes have made the issuance of covered bonds less attractive (Chart 1). Simultaneously, the issuance of unsecured debt declined by approximately 2% between 27 and 212. In the short term funding markets, there is also a clear shift from unsecured towards secured interbank funding. While unsecured interbank lending fell by half in the past decade, secured lending doubled (Chart 2). The rising trend in secured interbank funding, of which repos are the main instruments, is expected to continue. Various factors, such as the preferential treatment of repos under Basel III and the persistent strains in the unsecured interbank market, are likely to contribute to a further increase in repo funding. Another factor driving increased secured funding in the euro area is the liquidity operations of the European Central Bank (ECB). In response to market tensions, the ECB has expanded these operations and official collateralised funding has soared since 27 (Chart 3 and Chart 4). In its continued efforts to support the liquidity of euro area banks, the ECB lent over EUR 1 trillion (EUR 489 billion in December 211 and EUR 53 billion in February 212) under two longer term refinancing operations (LTROs). The net amount of additional loans is about half this sum, as this financing partly replaces other ECB liquidity operations. Nonetheless, on balance, this intervention has substantially increased the share of collateralised funding in the euro area. While reliance on secured funding has risen sharply in Europe, these funding levels vary substantially across banks and between countries. A first reason Chart 4 Bank assets pledged to tap ECB funding (EUR billions) 3, 2,5 2, 1,5 1, 5 24 25 26 27 28 29 21 211 Q3 212 Central government securities Regional government securities Uncovered bank bonds Covered bank bonds Note: Value of assets after haircuts and valuation of the ECB. Sources: ECB, DNB. Corporate bonds Asset-backed securities Other Assets Banque de France Financial Stability Review No. 17 April 213 199

is differences in bank business models. In particular, banks that specialise in mortgage lending often have a relatively high level of secured funding. This explains the large share of Danish covered bonds in the total issues within Europe. A second factor is differences in national market practices and legislation. Germany, for instance, has a long history of covered bond legislation that promoted the use of these instruments. German banks have therefore traditionally relied relatively heavily on secured funding, although this reliance has declined over the past decade. By contrast, other countries like the Netherlands (since 28) and Norway (since 212) have set ceilings on encumbrance levels, through bank specific limits on the issuance of covered bonds, thereby curbing the share of secured funding in banks financing schemes. 1 2 Derivatives Another market prompting increased collateral use is the derivatives market. Again the driving factors are both risk aversion and regulatory reforms. First, in the OTC derivatives market, collateral use surged after the crisis, reflecting both higher risks and tighter counterparty risk management. In fact, International Swaps and Derivatives Association (ISDA) estimates that the notional amount of collateral posted in OTC derivatives transactions almost doubled in 28. Although collateral use fell in the subsequent two years, in line with the decline in gross credit exposures, it picked up again in 211. Second, OTC derivatives market reforms, in response to problems in these markets during the crisis, are widely expected to reinforce this trend of increased demand for high quality collateral assets. While the reform process is still ongoing, key initiatives are the mandatory central clearing of standardised derivatives and the introduction of margin requirements for non standardised OTC derivatives. The former includes a requirement for central clearing parties to segregate member and client collateral. This will result in reduced netting, and hence in a higher demand for collateral assets. For the latter, new standards that discourage the re hypothecation of collateral are expected later this year. Higher margin requirements in both centrally and bilaterally cleared derivatives are boosting collateral demand. Initial margins are required to be posted by both parties to a centrally cleared derivative trade and a two way margin is proposed for bilateral OTC derivatives. These initial margin requirements will directly increase collateral demand. Moreover, restrictions on the re use or re hypothecation of collateral assets, while promoting financial stability through reduced interconnectedness, will result in a net increase in collateral demand. Although variation margin (daily payments reflecting changes in the market price of a derivative) will not directly increase collateral demand, it may do so indirectly. This is because market participants are likely to respond by holding additional buffers of eligible collateral to be used in times of heightened market volatility. Several studies have attempted to quantify the impact of the derivative market reforms on collateral demand, but outcomes vary widely on account of differences in methodologies and assumptions. The estimated total increase in collateral demand varies between several hundred billion and over one and one half trillion euro (e.g., Basel Committee on Banking Supervison (BCBS) International Organization of Securities Commission (IOSCO), 212; Bank of England, 212; International Monetary Fund (IMF), 212). A study by the Nederlandsche Bank (Levels and Capel, 212) focuses on the euro area and finds that an additional EUR 375 billion collateral is needed. This figure includes a correction for current under collateralisation and reduced possibilities for re hypothecation under the new regulation. 2 Collateral scarcity Greater collateral use in financial transactions together with the introduction of liquidity requirements may create a scarcity of high quality liquid assets. The key question is whether an increasing supply of such assets will keep pace with the increasing demand. 2 1 Demand for high quality liquid assets Rising collateral use in financial markets has boosted demand for assets that are highly liquid and have low credit risk. Besides greater collateral use in financial transactions, increased demand stems from the introduction of new liquidity regulation. The BCBS has introduced two new global standards under Basel III: the net stable funding ratio (NSFR) 2 Banque de France Financial Stability Review No. 17 April 213

and the liquidity coverage ratio (LCR). The NSFR aims to secure the longer term stability of funding, whereas the LCR focuses on short term resilience to liquidity stress. From the viewpoint of collateral scarcity the LCR is more relevant, as it requires banks to hold sufficient HQLA to withstand a severe stress scenario lasting one month. The additional demand for HQLA related to the introduction of the LCR is difficult to ascertain, because banks will adjust their behaviour to limit their increased need for such assets. For example, banks are likely to comply with the LCR in part by replacing short term with long term funding sources. Focusing on the euro area only, the initial increase in demand for HQLA is expected to be around EUR 9 billion (Levels and Capel, 212). This estimate likely needs to be significantly revised downwards, however, given the recent revisions to the LCR (BCBS, 213). In Europe, demand for safe assets will also increase from insurance companies as a result of Solvency II, because debt instruments with high ratings will enjoy a preferential regulatory treatment (CGFS, 211). This comes in addition to the already higher demand for safe assets from institutional investors that has been witnessed in recent years. Data are available for France, where the portfolio of safe assets in the insurance sector almost doubled from EUR.6 trillion in 27 to EUR 1.1 trillion in 211. Finally, rising official reserves also raise such demand, as countries invest their foreign exchange holdings in HQLA. 2 2 Supply of high quality liquid assets In the euro area, sovereign issuers are the dominant suppliers of HQLA. In recent years, government debt has grown substantially due to automatic stabilisation, discretionary stimulus packages and public support to financial institutions. Since the beginning of the financial crisis, the overall supply of debt issued by sovereigns has thus surged; this supply is expected to increase further on account of continued high budget deficits and still rising debt levels. However, not all government debt is considered as HQLA anymore. The increases in public debt levels are threatening the risk free status of sovereign debt, resulting in lower ratings and higher spreads on credit default swaps (CDSs). Chart 5 shows that the supply of government debt has indeed grown substantially, but that the quality of outstanding government debt has actually deteriorated. In fact, the total amount of outstanding government debt with the highest quality has even declined at the euro area level. The supply of HQLA can also increase on account of more so called quasi high quality liquid assets such Chart 5 Safe assets Government debt of EU countries, classified according the CDS spread (USD billions) 15, 1, 5, 21 22 23 24 25 26 27 28 29 21 211 Note: Period: Q4 21 Q4 211. Sources: IMF WEO, Datastream, DNB. 2 bp < 15-2 bp 1-15 bp 5-1 bp < 5 bp Unknown Banque de France Financial Stability Review No. 17 April 213 21

as covered bonds and corporate bonds. While the issuance of these instruments is also rising (Chart 1), the size of this market is small in comparison with that for sovereign debt and accounts for only one fourth of the total supply of assets that qualify as HQLA. Hence, an increase in the volumes of covered bonds and corporate bonds will only have a limited impact on the total supply. 2 3 Scarcity of high quality liquid assets These developments in demand and supply raise the question whether assets that can be used as collateral and to meet liquidity requirements are likely to become scarce. This is a difficult question to answer because, besides behavioural changes, estimates for the increase in demand and supply are hampered by data limitations and assumptions. However, Levels and Capel (212) can be taken as an approximation of the current and expected demand and supply of HQLA in the euro area. Demand for HQLA is estimated to grow by EUR 2, billion in the coming two years and supply by EUR 1,5 billion, resulting in greater scarcity of HQLA. These estimates are in line with a recent study by European Securities and Market Authority ESMA (213). Nonetheless, total supply of these assets will continue to outsize demand and hence no absolute shortage of collateral assets is to be expected in the near future (Chart 6). However, this situation varies markedly across jurisdictions. In the euro area, for instance, there is a clear distinction between banks in so called core countries such as Germany and the Netherlands, and banks headquartered in peripheral countries like Greece and Portugal. Many banks in these latter countries face shortages in HQLA that can be used as collateral. Outside Europe, Australia is an example of a jurisdiction with a shortage of HQLA: the government budget is in surplus and the outstanding debt level is low. To ensure banks access to liquidity in times of acute stress, the Reserve Bank of Australia will introduce a new committed facility in 215 enabling banks to enter into repurchase agreements of eligible securities outside the central bank s normal market operations and herewith to meet the LCR requirements. Eligibility criteria explicitly allow assets issued by bankruptcy remote vehicles, such as self securitised residential mortgage backed securities (RMBS), to avoid promoting excessive cross holdings of bank issued instruments. 2 4 Adverse implications of collateral scarcity Scarcity of high quality liquid assets that can be used as collateral will be reflected in a higher price for such assets. In turn, price changes will prompt endogenous private sector responses that may have adverse implications for the stability of the financial system. Specifically, more collateral transformation may be expected to lead to greater complexity, Charts 6 High quality collateral: supply and demand (EUR billions) 1, Supply 1, Demand 8, Extra until 214 8, 6, 6, 4, 212Q2 4, Extra until 214 2, 2, 212Q2 Quasi-high-quality collateral High-quality collateral Repo markets OTC derivatives markets Basel III LCR Central bank use Source: Levels and Capel (212). 22 Banque de France Financial Stability Review No. 17 April 213

opacity and interconnectedness, and will attach greater importance to the role of central banks in stabilising the financial cycle. role in dampening the financial cycle by broadening collateral acceptance when market participants narrow their collateral acceptance. More complexity and opacity in collateral structures A higher price for collateralised transactions also incentivises banks to create collateral that can be used for such transactions. While banks have already done so by pooling assets and over collateralising them, the creation of additional collateral assets generally involves more heterogeneous claims with more complexity and opacity. In periods of stress the actual quality and liquidity of these assets will be more difficult to establish and may turn out to be lower than expected. This occurred during the credit crisis, when the confidence of market participants in the underlying assets of some securitisations collapsed and virtually the whole securitisation market became highly illiquid. Greater interconnectedness through collateral lending Another likely reaction to price rises is that banks will expand their collateral lending activities. Banks with a surplus of HQLA will have an incentive to lend these out to those with a shortage. At the same time, banks with shortages will also attempt to borrow HQLA from other institutions such as insurance companies and central clearing parties. This development will increase interconnectedness within the financial system. Moreover, maturity and funding risks will increase since collateral lending transactions generally have a shorter maturity than the transactions they are used for. Finally, as these transactions are not publicly reported, transparency will decline. Accumulation of lower quality collateral assets in central banks As the price of HQLA rises, banks will try to use these assets more efficiently. By contrast, institutions that accept a range of collateral with fixed criteria for quality, value and liquidity, are likely to be offered the cheapest eligible assets. This is because the best quality assets will be used in market transactions to reduce costs related to risk premia. In practice, this means that especially central banks, via their market operations, will be confronted with a decreased quality of collateral in times of market stress. In effect, central banks may have a more important 3 Asset encumbrance Increasing collateral use in financial transactions leads to greater encumbrance of banks balance sheets. Rising asset encumbrance has a number of adverse implications for the stability of the financial system. 3 1 Sources of asset encumbrance Banks use various instruments to fund their business activities (Chart 7). These differ in terms of attributes such as maturity, seniority and collateralisation. This latter feature is present in short and long term secured funding instruments and in derivative exposures. Essentially, collateralisation means that a bank pledges assets to creditors in order to limit their loss given default (LGD); the assets pledged for this purpose are then encumbered. Long term secured funding is typically in the form of collateralised mortgage debt. Two types of instruments are common. The first type consist of covered bonds, which remain on the issuing bank balance sheet and add to asset encumbrance. The second type are RMBS, which are generally off balance sheet Chart 7 Sources of asset encumbrance Deposits Short-term market funding Long-term market funding Capital Off-balance { { { { Retail deposits Interbank funding Repos Commercial paper Covered bonds Senior unsecured Tier 2 Tier 1 Core Tier 1 Derivatives Sources of bank funding that can lead to asset encumbrance Banque de France Financial Stability Review No. 17 April 213 23

instruments. RMBS affect encumbrance only to the extent that issuing banks provide implicit or explicit guarantees, or retain the RMBS on their own balance sheet. For short term secured funding, repurchase arrangements (repos) are the most common instruments. These instruments play an important role in secured funding markets, including central bank liquidity provision. Repo positions are often offset through reverse repos, reducing the net contribution to asset encumbrance levels. Derivatives are another class of instruments that lead to asset encumbrance. Besides the initial collateral posted as margin, one counterparty typically accumulates claims against the other, as the value of the derivative contract changes over time. To limit counterparty credit risk, the debtor then posts additional collateral that increases the level of asset encumbrance. 3 2 Adverse implications of asset encumbrance High levels of asset encumbrance adversely impact the residual claims of unsecured creditors, raising their LGD. There are three reasons for this. First, banks typically over collateralise, thus pledging assets in excess of the nominal value of the bonds issued. This increases asset encumbrance relative to obtained funds, thereby lowering the amount of assets to satisfy residual claims in the event of default. Second, banks generally use better quality assets to back secured instruments, thus eroding the average quality of the assets backing claims of other creditors. Third, the cover pool of secured instruments is usually dynamic, obliging a bank to replenish weak assets with good quality assets over the life of the bond. By implication, the assets available to meet claims of other creditors can decline quickly, particularly under stressed market conditions. The increased risks for junior creditors will spur changes in market behaviour that may adversely impact the stability of the financial system. There are at least five ways in which this may occur. More procyclicality During economic downturns, the effects of the economic cycle on bank leverage and credit supply is amplified when the share of collateralised financial transactions is higher. In particular, falling collateral values and higher non performing assets in covered bond pools have to be compensated or replaced to maintain the desired credit ratings of the secured debt outstanding. Similarly, falling asset values and higher haircuts will imply that more assets need to be pledged to raise a given level of repo funding or to meet (initial) margin requirements on derivatives exposures. While the increased demand for collateral assets in such periods could turn out to be difficult to meet without reducing balance sheet leverage (e.g., via asset sales), funding constraints will typically also limit new banking activities. Institutional investors would likely add to these pressures by pulling back from securities lending and similar activities in times of financial stress. Other potentially destabilising dynamics can arise from cliff effects, for example when a particular asset class is no longer eligible for margin posting due to a rating downgrade or a tightening of credit standards (see CGFS, 21). Less scope for bail in Bail in legislation gives public authorities the power to convert into equity or write down subordinated and senior unsecured debt. The main objectives of bail in are to allow for recapitalisation in resolution and to ensure the continuity of a bank s critical economic functions, while minimising the need for governmental support and, by implication, taxpayers money. Bail in tools thus also reduce moral hazard by allocating losses to debt holders in the case of bank failure. As such, bail in has been identified as a key element of effective resolution regimes and is being vigorously pursued by the international financial community (FSB, 211). However, high levels of asset encumbrance and, conversely, low levels of unsecured funding reduce the scope of application of bail in and hence limit its effectiveness. Less access to unsecured funding The issuance of substantive amount of collateralised debt will reduce access to unsecured funding and may even precipitate a death spiral. As the investment risk for unsecured debt holders rises with the level of asset encumbrance, new unsecured creditors will become increasingly wary and may demand higher interest rate payments. This is especially likely to occur once bail in policies take effect. A rise in the cost of unsecured debt will pressure banks to increase reliance on secured funding, thereby further raising 24 Banque de France Financial Stability Review No. 17 April 213

asset encumbrance. Beyond a certain threshold level of asset encumbrance, and in absence of other risk mitigants, banks will find it increasingly difficult to retain access to unsecured funding markets. Risk shifting to deposit guarantee schemes In jurisdictions where retail depositors and senior unsecured debt holders enjoy the same seniority (i.e. rank pari passu), they face equal risks from asset encumbrance via greater losses in case of default. However, while the holders of senior unsecured debt will in principle demand compensation for any extra risk, the pricing of deposit insurance schemes is usually insensitive to the effects of changing loss given default ratios and balance sheet opacity. This means that banks with a large retail deposit base may find it attractive, from a cost perspective, to issue secured rather than unsecured debt, thereby shifting risks to depositors and the deposit guarantee scheme. Less monitoring of banks Traditionally, unsecured creditors play an important role in monitoring banks, as their incentive to acquire information is greater than that of insured depositors and secured creditors. However, if rising asset encumbrance reduces the role and number of unsecured creditors, this may lead to less bank monitoring and, in turn, more bank risk taking. However, the incentive to monitor a bank will increase for those counterparties bearing the higher risks. Consequently, shareholders as well as other creditors will have correspondingly greater incentives to monitor bank risk going forward. This will limit any effect on bank monitoring and risk taking. 4 Policy implications Increasing collateral use may raise complexity, opacity and interconnectedness in collateral structures, and asset encumbrance may increase procyclicality and risk shifting to deposit guarantee schemes, while reducing the monitoring of banks and the scope for bail in. Targeted policies can mitigate these drawbacks. A first policy recommendation is to improve transparency on asset encumbrance. If banks periodically publish the extent to which their assets are encumbered, and are available for encumbrance, other creditors will be better able to assess the actual risks they face. This will improve the pricing of funding. Higher asset encumbrance will gradually lead to higher bank funding costs and banks will face a time consistent incentive not to issue excessive secured funding. The extent of asset encumbrance should be included in the pricing of deposit guarantee schemes. After all, any increase in asset encumbrance will raise residual risks for such schemes, as well as for the government as the ultimate safety net. Since depositors will not factor in this increased risk because their deposits are guaranteed a higher premium will serve to discipline the bank. In other words, including encumbrance levels in guarantee premiums internalises the related risks for the guarantee scheme. Next to policy measures to internalise the risks of asset encumbrance, hard prudential limits can serve as a back stop. Various countries such as Australia, Canada and Singapore apply strict ceilings for the amount of covered funding or covered bonds. In the Netherlands, Norway and the United Kingdom a case by case approach is used that sets threshold values for covered bond issues per institution. Besides this, banks should perform regular stress tests that evaluate encumbrance levels in periods of market stress and the outcomes of such tests should be disclosed. Prudential supervisors should ensure that other financial institutions involved in collateral transformation and lending have adequate risk and collateral management arrangements in place. The risk management practices of these institutions should be designed to survive prolonged periods of heightened market strain without spill over effects to counterparties and the wider financial system. Finally, given increasing encumbrance levels, closer monitoring of collateral scarcity and asset encumbrance is well advised. Macroprudential authorities should monitor the demand and supply of collateral and related collateral lending, which increases interconnectedness within the financial system. This monitoring involves not only banks, but also institutional investors that engage in collateral lending, such as life insurance companies and pension funds. In this context, starting this year, the largest global banks are comprehensively reporting their activities and inter linkages, including to non bank counterparties. This detailed information should greatly improve our understanding of institution to institution exposures and of the resilience of the financial network. Banque de France Financial Stability Review No. 17 April 213 25

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