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The experience of the recent financial crisis has triggered regulatory changes, especially in the banking sector. The new Basel III banking standards will address some of the root causes of the financial crisis and aim to prevent another build-up of liquidity and solvency risks. The Basel III framework for liquidity risk regulation encompasses two ratios – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Both will have an impact on how banks manage their business activities.
With regard to the assets side of a bank’s balance sheet, a bank will primarily purchase High Quality Liquid Assets (HQLA) to improve LCR compliance. Holding these assets outright will improve the LCR. Demand for these assets is likely to increase, potentially causing them to trade at a premium. This regulatory-driven additional demand might reduce appetite for lower-quality liquid assets.
Turning to the liabilities side, banks with an LCR of below one will need to substitute short-term for longer-term funding. This could reduce the volume in the short-term unsecured interbank market, though banks will probably continue to engage in significant short-term unsecured trading for daily liquidity management purposes, as they will still need to fulfil reserve requirements. Central banks will have to monitor the impact the new liquidity regulations have on monetary policy implementation.
Repo market
The net impact on a bank’s liquidity position of increasing its level of repo funding is somewhat more complex, but overall it tends to improve the LCR and encourages a greater level of secured funding, irrespective of duration. However, the higher demand for good and liquid assets may reduce the supply for repo markets – potentially reducing liquidity in the secured repo markets and adding to market volatility, particularly in times of stress.
The ample liquidity provided by the Eurosystem, especially via the two three-year LTROs, together with the enlarged collateral framework for Eurosystem refinancing has led to reduced activity in this market segment, too. The decisive question for market participants now is whether the Eurosystem will stick to or reduce its non-standard monetary policy measures such as the full allotment policy and the enlarged collateral framework.
Another important factor on the repo market of the future will be the planned financial transaction tax (FTT). In its current design, it may harm the short-term repo market segment, as even a low tax rate of 0.1 per cent for trading a sovereign bond represents a high burden to short-term and revolving repo transactions.
Sovereign bond market
Government bond markets have suffered during the ongoing banking crisis, especially as it turned into a sovereign debt crisis. They are no longer considered a homogeneous, risk-free asset class. Investors’ willingness to take risk diminished sharply. Volatility and liquidity became the most important topics for market participants. Bond buyers exercised greater scrutiny and a series of rating downgrades prompted investors to re-evaluate their belief that European government bonds are risk-free assets. This led to a differentiated perception of European government bonds and diverging yields for the individual countries. To a certain degree, the increased spreads seem to be justified. They reflect diverging fundamentals in different countries – ie the different economic situation and levels of public debt. It is questionable whether the convergence of yields in the years before the crisis reflected the right assessment of the various risks underlying these investments.
Currently, refinancing conditions for the peripheral countries have improved notably. Hence, OMT will hopefully never have to be activated.
Lower investor confidence, besides sending European government bond yields and CDS premia higher in the secondary markets, has also impacted the primary markets. The space left by external creditors was occupied by domestic investors such as banks, who increased their investments particularly following the introduction of the three-year LTROs.
The current initiative to establish an effective Single Supervisory Mechanism is a step in the right direction. It will help us to identify risks at an earlier stage and is therefore also important for disentangling the critical link between sovereign and bank funding. However, the Banking Union, consisting of a sound Single Supervisory Mechanism and Single Resolution Mechanism, is a future project to prevent future problems. Existing burdens have to be treated separately. They arose under national responsibility and should not be mutualised. Therefore, the planned financial inventory of banks’ balance sheets is crucial and needs a close examination. Banks which do not have a sustainable business model should not be kept alive with public financial support.
Closing remarks
Overall, stress levels in the markets for European government bonds and bank refinancing have diminished significantly since the summer of 2012. Nevertheless, the question whether the interbank market will return to its former integrated status remains open. Secured trading in connection with the use of CCPs may play a crucial role in the changing environment as it reduces counterparty risk and helps to improve collateral management.
The ongoing repayments of the three-year LTROs reduces excess liquidity in the money market and could be interpreted as suggesting that market participants no longer need as much access to central bank liquidity as before. But let me be unequivocal about one thing: this development has been induced by the markets, it has not been triggered by the Eurosystem.
Furthermore, banks should focus on achieving a reasonable mix of short-term funding and refinancing via longer-term repos and bond issues. This could help alleviate the current tendency of some banks to leave their cash reserves in the ECB’s deposit facility rather than offering them in the interbank market. This would be an important step towards re-establishing a well-integrated money market in the euro area.
The regulatory steps undertaken with Basel III go in the right direction, but their impact on the markets has to be carefully considered.
In the banking sector, business models need further adjustments, which should ultimately result in a more resilient and diversified sector with a more sustainable risk-return profile. In the current low interest rate environment, it is surely no easy task to increase earnings. However, developments so far go in the right direction as e.g. German banks’ average equity base has improved considerably since the beginning of the crisis. For the 20 biggest credit institutions, the core capital rate has doubled on average.
Nonetheless, the interconnectedness between banks and their home country has to be monitored closely as it holds a strong contagion risk.