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.