Guest Post: Could Basel III Create A Floor For Sovereign Debt Prices?

Tyler Durden's picture

Some thoughts by David Schawel at Economic Musings who follows up on our observations from a week earlier regarding the possibility for a major Treasury collateral scramble if and when Basel III is ever implemented, and the implications for US Treasury demand.

Could Basel III Create A Floor For Sovereign Debt Prices?

The evolution of regulatory reform in the banking industry has
been well publicized since the onset of the credit crisis. Whether it’s
a talking head on CNBC or a central banker’s op-ed, everyone seems to
have an opinion.  In tandem with Dodd-Frank, the new Basel III will
affect all US Banks.  In addition to the increased capital requirements,
liquidity requirements will also change.

A major component of
the new Basel III requirements will be a LCR ratio.  This compares high
quality liquid assets (numerator) with stressed net cumulative cash
outflows over a 30 day period (denominator).  The ratio must exceed
100%.  It essentially tests whether you have enough highly liquid assets
(i.e. cash, treasuries, etc) to liquidate at little/no loss and cover a
stressed scenario of cash outflows.  This requirement will be effective
as of 2015.

Highly Liquid Assets:  Treasuries, Ginnie Mae MBS,
Cash at the Fed, and certain Sovereign Debt are all 0% risk weighted.
 20% risk weighted assets such as Agency Debt and Agency MBS would be
limited to 1/3rd of the amount of eligible 0% risk weighted assets.
 Thus, non-agency MBS, CDO’s etc would all not be eligible irrespective
of the credit rating.  Obviously the focus here is highly liquid - how
quickly could it be sold without a material haircut. 

This LCR
requirement would assume the bank has fully drawn down on other lines of
credit & liquidity facilities.  Suffice to say the majority of
banks do not run a liquidity position that have
sufficient highly liquid assets (according to the definition above) to
cover a highly stressed scenario.  Banks count on lines of credit and
even Fed borrowings “lender of last resort” in their liquidity planning.

my opinion, the implications of this are crystal clear: banks will
obviously need to dramatically ramp up their holdings of these
securities (mainly treasuries) in order to comply with the LCR ratio.
 This could provide a significant tailwind to treasury demand over the
near to intermediate term.  S&P says it best, “We believe there is a
risk that this standard is too conservative- to the point where it
could create a shortage of liquid assets…”  

estimates the liquidity shortfall of meeting this requirement is
~$800billion.   According to the Federal Reserve flow of funds report
(table L.109) released this month, US banks held ~$300billion of
treasuries.  I believe that estimate may prove to be light as
institutions will no doubt look to achieve a healthy buffer to appease
This LCR requirement is a game changer in terms
of liquidity, and could arguably create a floor for sovereign debt
prices across the US & Europe.

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SheepDog-One's picture

There are regulators that need to be appeased? What?

Greeny's picture

"McKinsey estimates the liquidity shortfall of meeting this requirement is ~$800billion."

So? Bernank will need additional liquidity pumping

in the "system" near 1 trillion $. QE3?

zaknick's picture

Funny money shell game.

hedgeless_horseman's picture
Darth Geithner: And the banks, they are still buying treasuries eventhough QE is ending?
Nute Gunray: The bids have... disappeared, my Lord. One Dagong report got past the blockade.
Darth Geithner: [snarls] I want those auctions bid!
Nute Gunray: M-my lord, it-it's impossible to locate buyers. The U.S. is now out of the banks' risk profile.
Darth Geithner: Not for a Sith. This is my new LCR requirement, a part of Basil III. It will create your lost treasury bids.
Nute Gunray: This is getting out of hand! Now there are three of them!
Rune Haako: We should have not made this bargain.
swissinv's picture

Another try to find a bullish reason to buy CCC treasuries. Banks outside the US with lower inflation will rather deposit the cash at 0% at the national bank than going into this experiment... Apart from that there are also good quality gov. bonds available like "Deutsche Bundesanleihen" or SGS.

dasein211's picture

Bullshit. This isn't going to be implemented until2015! The house is on fire NOW! Even if they want to move to liquid assets the default of soverign and US debt is a very realistic event. Even if you wanted to add liquidity the FORM that takes is in question right now. Whats the dollar or the Euro or treasuries going to be worth in two years. Even in a deflation if you can't pay your debt the debt instrument will be worthless and no one will want to deposit that turd in their banking toilets. We all know where the safe long term haven is right now no matter how many times they extend and rig the markets. Math is a bitch.

oogs66's picture

2015?  If it doesn't suit the banks it will be pushed back another couple of years anyways.

SheepDog-One's picture

Yes the house is burning to the ground, but no problem theres word a tiny firetruck driven by 2 spider monkeys will show up 4 years from now!

Sean7k's picture

So, we're talking about tying up additional capital in US debt instruments? Debt that is defaulting? Or, is this just a deal to absorb Japanese and Chinese bond sales? 

Europe is talking about reducing Basel III capital requirements because their banks are not able to meet the new standards, but US banks won't?

They just suspended the derivative market requirements from DonginFwank, but they will require these?

I won't hold my breath. 

ping's picture

So, can anyone recommend a good, basic Swiss Bank account? I sure as hell don't want my money here. 

cm44888's picture

This is old news and poorly reasoned
Banks are unlikely to buy govt debt outright to meet the LCR (too much duration risk and no desire to hedge in case they might need to sell quickly)

Maybe they will reverse repo govt debt for short term. This won't suppress yields

Most likely they will hold cash at central banks.

Nobody wants to own that toxic sovereign stuff

narnia's picture

Any argument that the market floor for sovereign debt is greater than zero long term... is not based in reality.

archfool's picture

The Bernank has outsmarted us again! Currently FedR buys 70% of treasuries.... this new move will create demand for treasuries. Banks will start loading up now to meet 2015 deadlines for "on hand liquidity" HOWEVER... in the NEXT systemic crash... what then happens to price of treasuries? In a Major Banking Event, you WANT treauries to keep stable as a "safe haven" They cannot be a safe haven if everybody sells en masse to CYA. BOOM... treasuries implode instantly. THAT is how the Treasury Bubble will implode. Holy Shit. They've been PLANNING to pop the bubble!

fbrothers's picture

And Treasuries will be worthless.

Everybodys All American's picture

Really incredible ... create you own demand through legislation and tell everyone it's about making the banks more stable.

Poor Grogman's picture

That's why they pay these guys the big bucks.

PHDs in Ponzinomics and Sleight of hand.

Unlike those pesky inedible metals, the new form of ponzi wealth is unlimited.

Everyone a millionaire, gotta love that ponzi....

oogs66's picture

The governments and the banks have never done a good job estimating liquidity.  More importantly, if they all hold the same 'liquid' assets and all need to sell them at the same time, what are the chances they will be so 'liquid' at the time?  About zero.

Then in the meantime, banks will find some way to create the riskiest investment possible that still meets the legal definitions of the liquidity requirement and that is all they will own.

AAA CMO's did not invent themselves.  They got created because they were the cheapest AAA paper out there and risk departments viewed them as very safe and very liquid so banks and others could build massive positions. 


Even if these rules ever get implemented, they will likely fail to work when finally required.


JLee2027's picture

Wouldn't this demand only be temporary? 500 billion of treasuries...the Government prints that in a couple months.

AldoHux_IV's picture

Sounds more like me that capital and risk-- especially relating to liquid/safe assets are grossly mispriced and understood by Dodd-Frank, regulators, and banks.

youngandhealthy's picture

Hahahaha....its hilarious. No one can take this seriously...Basel III is 2019 and hybrids are still being allowed. PDs R trying to lure people in and buying 10s at ridiculous prices

dcb's picture

well we all know sovreigns carry zero risk.

I hate when they do stupid stuff like this. that is one of the ain problems with the system is a "risk free rate". that does not exist!!!

dcb's picture

oh, I think the next potential s and P short is about 1325!!

ivana's picture

no f... way.

You need Basel MCMVXIII for that

Anyway any of Basels don't apply for TBTFs, correct?

Cthonic's picture

Could someone explicate how in the world these ad hoc Basel agreements gain the force (or color) of law in U.S. jurisdiction without a ratified treaty and or why no Fed member banks complain about such arbitrary regulator discretion in adopting the same?

gillimus's picture

Because it's crap.  Imagine all your friends from college getting together and having a party.  There is no DD so you all agree not to drink too much, and write up a contract that states you will all be sober in 4 years.  In the meantime, kegs are tapped and shots are shat and someone drives into a tree.  But hey, you agreed to get your shit together in 2015, so it's all good.