Guest Blog from Benedict Roth,
Risk Management Expert
[Note to readers: This is the second time we have had a guest blog, the first one from Eric Jensen: "On the Ethical Implications of Short Selling". This time it is from Benedict Roth, a risk management expert and former colleague of mine at two different banks - RZ]
Sir Paul Tucker, a previous Deputy Governor of the Bank of England, warned in the FT last month of a new financial crisis. He may be right: March’s equity market collapse was accompanied by a puzzling and unprecedented liquidity crisis in cash government bonds. Investors dumped gilts and Treasuries. The repo rates implied by the cash/futures basis on the US 10y note reached 8%.
Eventually, central bankers stepped in. UK authorities purchased £200bn of gilts; their US counterparts $1,000bn of Treasuries; the Federal Reserve took $285bn of private-sector secured deposits into its reverse repo facility, bypassing the banking system entirely.
But Sir Paul’s proposal – to widen the regulatory net and turn central bankers into ‘market-makers of last resort’ – missed the point. Last March’s liquidity crisis was a product of the regulatory framework itself and of regulators like Sir Paul. The next crisis will only be averted by making the framework smarter. Wider regulation, with more regulators, is not the answer.
Look at the leverage ratio
The culprit is the leverage ratio, which obliges banks to hold equity capital at approximately 4% of total assets. The leverage ratio makes no distinction between banking assets like loans and liquidity assets like gilts, US Treasuries and government bond repos.
Banks’ capital resources are fixed: they can’t turn to shareholders for new equity as they please. If a bank holds an extra dollar of liquidity, the leverage ratio makes it close down a dollar of its loan book. If it accepts a new deposit, even when deployed into first-class liquid assets like T-bills or cash repo against T-bills, it can burst its ratios.
Little wonder that in March last year banks were unwilling to make markets in bonds, finance clients’ trading positions, or use their balance sheets to buy and hold bonds: the crisis coincided with end-quarter financial reporting and no CFO, in a crisis, wants to report weak ratios.
Squeeze on cash repo
Before the leverage ratio, secured liquidity and deposit facilities – core functions of the banking system and essential to their public purpose – had been provided liberally via repo to institutional clients or inter-bank counterparties at spreads of only a few basis points, the corporate equivalent of the free personal current account.
No longer. Leverage ratios have driven banks’ repo books away from cash into security-for-security transactions, which are off-balance-sheet and therefore off-leverage, or agency transactions which evade leverage almost entirely. These may be useful for some asset managers but do little for the cash markets which lie at the heart of today’s financial system.
Systemic financial stability?
Today’s banks report giant liquidity buffers of government bonds but cannot convert them to cash when needed: regulation has evaporated so much liquidity from private cash repo markets that central bankers, once lenders of last resort, have become the first port of call in a storm for any large commercial bank.
Temporary fixes didn’t include cash repo
After March’s bond market rout, US authorities exempted domestic government bonds and central bank deposits from leverage, on a temporary basis. They requested comment on the idea of exempting bond repo too.
UK authorities had already exempted central bank deposits from leverage, again on a temporary basis. The EU followed late last year.
But neither of these initiatives carried the permanence or conviction to alter international consensus. Banks’ assets remained capped.
And neither the UK nor the EU initiatives mentioned cash repo. Their restriction of leverage ratio exemptions to central bank deposits encouraged banks to place liquidity centrally rather than lending it to one another and to their clients.
Instead of deepening the private-sector cash market, they centralised and socialised it. This was not the vision of post-crisis reformers, who wanted banks to rely on their own financial resources rather than public-sector support.
Now, after EU exit, UK regulators could build on the US lead, creating permanent leverage exemptions for safe-haven liquidity assets and providing equal treatment for domestic-currency government bond repo, the underlying government bonds themselves, and central bank deposits.
To prevent abuse, they should temper these exemptions by closing down some loop-holes: off-balance-sheet repo should be treated consistently with its on-balance-sheet cousins while repo credit risk and market risk on government bonds held at historic cost in banks’ liquidity buffers both require review.
Fixing the leverage ratio would free up post-pandemic bank lending and, by reviving the repo and cash bond markets, would enhance global financial stability. It would show that the UK still leads in smart, right-sized financial regulation. It could be the tipping-point for a re-balancing of regulatory consensus world-wide.
If not now, before the next crisis, when?