Treasury hunting

Basel III’s liquidity coverage ratio has driven increased bank demand for sovereign and agency issued debt, but as the ECB begins quantitative easing, the supply of high-quality liquid assets may come under pressure.

International standards for bank regulation historically focused mainly on capital ratios, but the financial crisis highlighted the need for banks to also maintain a stash of highly liquid assets to get them through periods of stress. In 2015, banks are for the first time being mandated to stock up their so-called liquidity buffers, which is creating increased demand for SSA issued debt, changing the dynamics of a market in which banks have only recently become major investors.

“Bank treasuries may increasingly see themselves as profit centres rather than just managers of liquidity, and diversification away from central bank deposits into the SSA space offers a way of enhancing returns. In the long term, it remains to be seen how banks will manage their balance sheets, but certainly over the next three to five years, they will have to remain very active in this space to keep their liquidity buffers topped up,” said Greg Arkus, head of SSA DCM and syndicate at Credit Suisse.

The introduction of a mandatory liquidity buffer comes in the form of the liquidity coverage ratio, one of two liquidity standards enshrined in the new Basel III framework. The LCR requires banks to hold a sufficient stock of high-quality liquid assets (HQLAs) to cover the difference between their expected cash outflows and inflows during a 30-day period of stress, as defined by supervisors.

While national regulators’ interpretations of the Basel III standard may vary in some cases, the definition of HQLAs typically gives precedence to SSA assets. In European legislation, for example, HQLAs are defined as those that can be sold on private markets with little or no loss of value. Central bank deposits and government bonds are included as level-one HQLAs, representing the most liquid assets that can be included in the buffer without any discount to their market value.

“The LCR rules favour sovereign debt which, if highly rated or, in Europe if issued by an EU member state, can make up the whole of the liquidity buffer and can be included at full face value without any discount or haircut.

Demand for those assets will be sustained over the coming years, because as bonds mature and are paid out, they will need to be replaced,” said Kevin Hawken, a partner in the finance group at law firm Mayer Brown.

The LCR is set to begin implementation on a phased basis this year, according to the Basel Committee’s timeline. While phasing arrangements may vary in different regions, most bank treasuries will have been buying up the necessary assets for some time to ensure readiness ahead of the deadline.

A Basel III monitoring report, published by the Basel Committee in September 2014, found that the average LCR among Group 1 banks (those with Tier 1 capital ratios above €3bn) was already as high as 119%, while for all other banks it was 132%. Of the sample of 227 banks included in the monitoring exercise, 76% already met or exceeded the final LCR minimum requirement, while 92% had LCRs at or above the initial minimum ratio of 60% required at the start of phase-in.

While specific data on the volume of SSA debt making up liquidity buffers are not available, anecdotal evidence suggests it could be high, particularly in Europe, where final prudential rules for the LCR were adopted by the European Commission in October 2014 as part of CRD IV, with implementation set to begin on October 1 2015. In line with Basel Committee standards, banks will be expected to meet 60% of the ratio at that time, rising on a phased basis to 100% by the start of 2018.

“Banks have become a much more significant part of the buyer base for SSA assets as implementation of the LCR gets closer. Regulators are moving at different paces globally, but European banks are most active now that the CRD IV rules have been finalised and they know what they need to invest in. In the US we are seeing the treasuries of the major global banks investing as they adopt the rules, but not the smaller regional banks,” said Arkus.

In the US, the final rule on the LCR was issued by federal banking regulators in September, and implementation is actually proceeding faster than in Europe. An 80% ratio became effective for covered companies at the start of this year, rising to 90% in 2016 and 100% in 2017.

Given US banks are facing a more accelerated implementation than their European counterparts, it may appear surprising that dealers have so far found demand for sovereign debt to be more patchy in the US. One explanation could be the greater availability of other types of assets for inclusion in US banks’ liquidity buffers.

“There may be less buying of sovereign debt among US banks because there is more supply of other asset classes than in Europe. In the US, there is a greater volume of highly rated corporate bonds available, so banks can choose to stock their liquidity buffers with those assets, whereas in Europe there is more sovereign debt compared with other eligible assets,” said Hawken.

Despite regional variations, few expect the increased demand for SSA assets to slow any time soon, creating an additional source of buying pressure in a sector that is already somewhat overstretched. As the European Central Bank prepares to begin its €60bn per month QE venture, which will see it buying up a range of assets including sovereign and agency debt, there may be limits to the volume of high-quality bonds available to banks in the future.

“With the advent of QE, it is likely that core yields will be driven lower and that they will remain low for a longer period of time. As a result, the relative value of SSA debt compared with other asset classes will diminish. The ECB will purchase government and selected SSA bonds, which will lead to more limited remaining supply, but ultimately price will dictate what bank treasuries buy to meet the LCR, not supply volume,” said Sean Taor, head of European DCM and syndicate at RBC Capital Markets.

Tightening spreads and low interest rates have already put pressure on investors, decreasing returns on assets at the short to intermediate part of the curve. This has led many investors to seek longer-dated bonds in the hope of generating better returns, and dealers expect that trend to continue as QE gets started in the eurozone.

“Central banks and official institutions are significant buyers of SSA assets and they tend to get strong allocations, given that they are high-quality accounts that are seen as buy-and-hold investors. As overall demand continues to increase, asset managers may find that they are not able to buy as much of the asset class as they did in the past”

“Many banks are pushing further out along the curve to lock in positive spreads to swaps wherever they can. For example, the 10-year supply of SSA debt was historically distributed mainly to asset managers, insurers and pension funds, but bank treasuries now make up around 50% of the demand for that tenor,” said Arkus.

With sovereign bonds being snapped up by both commercial banks and central banks in Europe, there could be an impact on liquidity in the secondary market, as a greater proportion of bonds are held to maturity and some buyside investors find themselves receiving smaller allocations than in the past.

“Central banks and official institutions are significant buyers of SSA assets and they tend to get strong allocations, given that they are high-quality accounts that are seen as buy-and-hold investors. As overall demand continues to increase, asset managers may find that they are not able to buy as much of the asset class as they did in the past,” said Arkus.

Other dealers see it the same way. “As banks have become larger investors in this space, some others who have historically been active have become less active. Banks typically buy bonds and hold them to maturity, which does potentially affect liquidity in the secondary market, and issuers have seen overall secondary trading volumes fall,” said Taor.

While the advent of the LCR may have had the biggest impact on the SSA sector in recent years, other regulations looming on the horizon also threaten to bring unintended consequences. One area of particular concern is the review of the Markets in Financial Instruments Directive, which is heading steadily towards implementation in the EU in 2017.

MiFID’s reach extends across a broad range of products and practices, but it is its push to increase pre and post-trade transparency that some fear could lead to lower liquidity and increased volatility in fixed-income markets.

“Whilst some may argue that more transparency is good for markets, I do not necessarily agree. Too much transparency will lead to traders wanting to take less risk, as they would not want other dealers to know their prices, their trades, or their positions. As a result, markets would become less liquid, which is not good for issuers, banks, or investors,” said Taor.