By Gregory Turnbull-Schwartz, fixed income manager, Kames Capital
Banking regulators are reported to be considering allowing single ‘A’ rated corporate bonds as part of the required liquidity buffers of banks. There are several reasons why this is a bad idea.
Liquidity buffers exist to protect banks against the risk that their natural liquidity shortage (they tend to borrow shortterm and lend long-term) becomes a fundamental credit issue, as we saw in the 2008 period. The point in restricting qualifying assets to highly rated government bonds and ‘AA’-category corporate bonds and above is that these should be convertible to cash on relatively short notice should the need arise. If an asset cannot be converted to cash on short notice, there is no point including it in a liquidity buffer. When capital markets seized up in 2008 causing liquidity problems for the banks, the corporate bond market was part of the event. Sterling bond market participants can quibble over whether the liquid transaction size at that time was £3m or £5m, or zero in some instances, but none would argue that if someone were to try to sell a large block of bonds to meet a need for cash, it would have been possible at prices anywhere near what was being shown in indices. Sterling was not the only market so afflicted. If any bank had held large pools of ‘A’ rated corporate bonds, for liquidity purposes, and needed to realise that cash, it would have failed to do so. In fact, the mere presence of a large seller of such bonds would exacerbate the problem, causing a self-fulfilling spiral. Traders are unsurprisingly reluctant to bid on bonds when they fear there may be a lot more of similar ilk coming to market. Given that traders are also employees of banks, that awareness is acute and they will not be extending liquidity to the secondary bond market when there is a liquidity crunch underway. A further twist on this story is that the composition of the ‘A’ rated corporate bond market is not especially promising. Thirty-six percent of the sterling corporate ‘A’-rated market consists of financials, and 25% is specifically banks. If banks are allowed to buy the bonds of other banks in order to increase their liquidity reserve, we will have crossed yet another line of demarcation between having functioning capital markets and being delusional capitalists, believing in market- based allocation of capital as a matter of faith rather than reality. If banks are not permitted to buy the bonds of other banks, regulators beware, as there will soon be new classes of bonds attempting to arbitrage between the desire of banks to hold ‘A’-rated corporate bonds in their liquidity pools and the desire of banks to raise debt via qualifying bonds to take advantage of that desire, possibly via nonbank intermediaries. In addition to removing the value behind the liquidity ratio, by changing the definition of ‘liquidity’ the measure to include illiquid assets in the liquidity pool calculation has a potent and long-lasting side effect that should dissuade the bank-patient from taking the meds… the banking system has been shown to lack transparency and not merit investor confidence. This would be simply one more reason to mistrust the figures that we see from banks. If regulators want to ease the burden on the banks, they would serve their role much better by remaining clear on this issue. What you see as an investor as part of a liquidity buffer must be assets that are actually convertible into cash on short notice. Rather than ease the burden by stirring up complexity, introducing yet more subjectivity and further muddying the waters of bank financial statements and regulatory filings, regulators should simply lower the required ratio. That would be preferable to pretending there is liquidity when in fact there is not.
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