FT Alphaville has been researching the issue of so-called ‘liquidity transfers’ ever since we first came across the matter in Life & Pension Risk in October.
As Risk noted at the time, there’s been an increasing trend for banks to swap their illiquid Asset-Backed Securities (ABS)-style assets for much more liquid securities held by pension and insurance funds via extremely long repo arrangements.
According to our sources, some of these swaps have even been structured for durations of as long as 30 to 50 years.
It’s all a bit of a quid pro quo arrangement.
Banks gets access to liquid securities, while pension funds and insurance funds get the means to manage their long-term liabilities more reliably by receiving a yield-related fee for the swap arrangement. Very useful in a Zirp environment.
As we commented at the time too, it was a move that could well be described as the privatisation of potentially expiring central bank liquidity operations.
Digging up actual figures or volumes about these sorts of arrangements in the interim, however, has been a bit of a thankless task.
The deals are mostly bilateral over-the-counter agreements, and banks have thus far not been keen to divulge details.
On Friday, however, the Bank of England’s Financial Stability Report turned its attention to the trend.
An extract from its “recent developments in bank funding markets” — to be found on page 38 — noted the following for example:
UK banks, in common with other banks internationally, face a significant funding challenge. Extraordinary public sector support will cease and banks will need to fund themselves independently. They also need to lengthen the maturity and increase the diversity of their funding.
Investors are demanding strengthened balance sheets and banks face new regulatory rules. At the same time, some investors in bank debt are looking for yield pickup and reacting to changes in their own regulatory rules.
In response, new wholesale funding instruments have emerged over the past six months. These are designed to help meet these challenges, although they currently represent a small proportion of total liabilities. This box looks at three of these instruments: putable certificates of deposit (CDs), extendible repos and long-dated secured funding. Table 1 summarises the main characteristics of these instruments.
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These new funding instruments could also potentially help UK banks broaden their investor base.
For example, there is some interest from asset managers and insurers in long-dated repos, as well as collateral swaps which give banks government bonds (in return for ABS), which can then be used to raise funding. Both extendible and long-dated secured funding also provide a natural home for some of the collateral that is being freed up by maturing Special Liquidity Scheme (SLS) collateral swaps.Indeed, the long-dated repo market can be seen in some
respects as providing a private sector replacement for the SLS.
Which, of course, establishes some sort of official corroboration of this being a revitalised funding-market trend post crisis in Europe.
Furthermore, while we weren’t too sure about the systemic implications of such trades the last time we wrote about the subject, the BoE offers up some more specific thoughts about the matter:
Despite these benefits, there are also risks associated with these instruments that banks and regulatory authorities need to be aware of, especially if these markets continue to grow. First, it is important that a conservative view on the effective maturity of these instruments is embedded within banks’ liquidity stress testing.
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… there are a number of risks that can arise from collateralised transactions. Under certain conditions funding can be withdrawn, such as following an event of default — there is ‘putback’ risk. Repo transactions can generate procyclicality, with margin calls for more collateral required if the collateral reduces in value. There is also the risk for unsecured creditors that, in the event of default, they will have recourse to fewer unencumbered assets due to a higher amount of assets being tied up in repos.
Finally, and most importantly, these instruments have mainly had the effect of redistributing liquidity risk around the banking system, rather than materially attracting unleveraged, non-bank investors into the bank funding market. So from a systemic perspective, it is not clear that these instruments have noticeably reduced aggregate liquidity risk in the banking sector or truly diversified sources of funding across the system.
One thing which is clear; more disclosure about the nature, type and frequency of these deals, would certainly seem desirable.
(H/T Paul J Davies.)
Related links:
It’s stock lending, Jim, but not as you know it – FT Alphaville
In the land of two-tier rates – FT Alphaville
‘General collateral remains puzzlingly inverted to fed funds’ – FT Alphaville