Undercapitalised banks within the crosshairs of a market rout can anticipate counterparties to demand increased margin calls, notably when a variety of its property are already encumbered, as is the case at many European banks. This can be a drawback of the European Central Financial institution’s making and one which solely it may repair. Making lined bond repo haircuts extra extreme could be place to begin.
As a agency encumbers a better proportion of its property — when it, for instance, pledges them to safe liabilities in, say, the repo or derivatives markets — it is going to have much less room to supply related safety when markets fall underneath stress, stated the Financial institution of England in a session paper on asset encumbrance in September 2019.
This makes it much less resilient to market stress and collectors are prone to cost it increased spreads, or reply extra shortly to indicators of stress. That can influence the financial institution’s potential to fund itself.
Since that warning, asset encumbrance ranges have risen steeply, sufficient to make the European Banking Authority challenge a thinly veiled warning to the ECB printed final week, that stated supervisory authorities wanted to “concentrate” to the scenario.
The EBA highlighted “in depth use” of central financial institution liquidity amenities, noting that encumbrance of central bank-eligible property within the EU had “elevated considerably,” to nearly half of eligible property, as of June 2020.
“Within the first half of 2020, the quantity of whole property and collateral obtained rose by nearly 10% whereas encumbered property and collateral elevated by greater than 20%,” stated the EBA. “Consequently, in June 2020, the asset encumbrance ratio rose to 27.5% [from 25% the previous year].”
As asset encumbrance rises the market’s confidence in a financial institution the place capital was constrained could be anticipated to decrease and counterparties would then search bigger haircuts on collateral and make margin calls — giving rise to what the BoE described as an “antagonistic suggestions loop”.
Confronted with this dilemma, the ECB has an obligation to reverse the course of asset encumbrance and encourage banks to hunt extra market funding, slightly than preserve and even deepen its already beneficiant funding preparations. However with the lockdowns which have spurred these measures proving longer and stricter than anticipated, the central financial institution is extra prone to bathe the market with further liquidity, resulting in an additional rise in asset encumbrance within the close to time period.
The ECB is aware of it is going to ultimately be obliged to encourage prudent behaviour. However it has made a rod for its personal again in that it has inspired the view that it’s regular to take central financial institution liquidity, slightly than pay what the market decides, to the purpose that there’s now a stigma for not taking it.
In the long term this behaviour is neither prudent nor sustainable and in some unspecified time in the future it must be reined in. Paying much less to repo banks’ retained lined bonds — that’s to say elevating the repo haircuts — would appear like place to begin.
It’s because lined bonds are the most important asset class pledged for repo on the ECB and supply the following least expensive supply of funding. The EBA identified that asset encumbrance was highest the place lined bond issuance was a “predominant funding software”, just like the Nordics or Germany, or the place repo was an vital funding software, akin to France, or in international locations the place banks have relied upon central financial institution funding lately, akin to Spain and Italy.
Lined bonds additionally profit from a central financial institution buy programme that may easy bothersome worth fluctuations for when issuers head again into the market — not that they need to want it: lined bond traders have been starved of regular ranges of provide for years.
The issue of rising asset encumbrance is one that’s prone to worsen earlier than it will get higher, however by beginning with lined bonds, it’s actually one which the ECB can start to repair.