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.
In 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…”
McKinsey 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 regulators.
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.