The Demand (and Supply) of High Quality Liquid Collateral Post Financial Crisis

1. The Demand (and Supply) of High Quality Liquid Collateral Post Financial Crisis REFORM: THE NEW ODYSSEY FOR DEVELOPMENT TSINGHUA PBCSF GLOBAL FINANCE FORUM MAY 10-12, 2014 Sean D. Campbell Deputy Associate Director Division of Research and Statistics Federal Reserve Board Washington D.C, 20551

2. Disclaimer • The views expressed in this talk are those of the presenter and should not be attributed to the Board of governors of the Federal Reserve System or other members of its staff.

3. The Financial Crisis and Liquidity Risk • Liquidity risk was a critical aspect of the financial crisis • Leading up to the crisis private markets created significant amounts of instruments (ABCP, AAA securitizations) that satisfied private demands for liquidity • Liquidity, however, is usually not intrinsic or “guaranteed” but depends on an ongoing willingness to treat an asset as “liquid” • The crisis was, in part, a period of spiking demand for liquidity and a substantial reduction in the instruments that were deemed “liquid”

4. The Financial Crisis and Liquidity Risk • “The multiple instances of run-like behavior during the crisis, together with the associated sharp increases in liquidity premiums and dysfunction in many markets, motivated much of the Federal Reserve’s policy response.” – Ben Bernanke, 4/2012 • The “liquidity run” affected both traditional banks and “so-called“ shadow banks. • Fed crisis policies aimed to provide liquidity to both sectors but harder to accomplish for shadow banks (PDCF, AMLF)

5. Post Financial Crisis Reform Agenda • Following the financial crisis, global regulators quickly determined that additional liquidity regulation was required to improve the resiliency of the financial system. • Some aspects of reform program targets traditional banks - Liquidity Coverage Ratio (NSFR) • Other aspects target shadow banking – Central Clearing of Derivatives and Margin Requirements for Non-Cleared Derivatives

6. Liquidity Coverage Ratio (LCR) • In January 2013, the BCBS agreed to comprehensive liquidity regulation (LCR) • The reform (LCR) recognizes that banking is a “liquidity business” and that, in addition to ample capital, banks need appropriate liquidity buffers to manage ongoing demands of their clients and counterparties • The notion that banks need a liquidity buffer is, of course, not entirely new. Reserve requirements have been used since the Panic of 1837! • Liquidity requirements also reduce the extent to which the central bank must rely on LOLR which can be important in a crisis when the line between “illiquidity” and “insolvency” blurs.

7. Liquidity Coverage Ratio (LCR) • In the intervening 180 years the liquidity services offered by banks expanded greatly – modern banks do much more than finance term loans with demand deposits • Modern LCR recognizes multiple sources of liquidity demand that require a liquid asset buffer • Wholesale unsecured funding • Secured funding • Derivatives (“off balance sheet funding”)

8. Liquidity Coverage Ratio (LCR) • Under LCR banks are required to hold “High Quality Liquid Assets” (HQLA) in an amount to withstand liability run-off during a 30 day stress period. • HQLA takes the form of: • Currency/Reserves (traditional measure of “liquidity buffer” ) • Sovereign bonds (with restrictions) • Corporate bonds/Covered bonds (with restrictions) • RMBS/Common Equity (with restrictions) • LCR recognizes expansion of both liabilities that require a liquidity buffer and assets that can provide meaningful liquidity in times of stress

9. Liquidity Coverage Ratio (LCR) • A liquidity requirement is a sensible response to the liquidity run of 2008 but what is the cost of the requirement? • How much HQLA will banks have to raise and hold on balance sheet to meet the requirement? • The question is both important and difficult to answer with any specificity – i.e., Lucas Critique • Static analysis suggests banks will need to hold an additional$1.6 trillion

10. Derivative Reform: Clearing and Margin • LCR is a useful supplement to robust capital requirements but is limited as it only applies to banks. • The financial system has evolved considerably to include a range of non-bank intermediaries such as “shadow banks”. • Derivative markets are a key example and derivative market failures played an important role in the crisis

11. The Role of Derivatives in the Financial System • Derivatives are an important and growing source of liquidity and funding to the financial system

12. Derivative Reform: Clearing and Margin • In September 2009 the G-20 determined that standardized OTC derivatives should be centrally cleared • Central clearing is now happening in the US with the largest and most heavily traded IRS and CDS being centrally cleared. • In September of 2013, BCBS and IOSCO agreed on international standard that will require all non-cleared derivatives (perhaps as much as 50% of all derivatives) to be margined: variation and initial margin • Europe has released a proposal for implementing these requirements: US and others to follow…..

13. Derivative Reform: Clearing and Margin • Going forward clearing and margining requirements will require substantial amounts of initial margin collateral to be provided by derivative market participants • initial margin as a performance bond • initial margin as a check on leverage created through derivatives • How much initial margin will be needed to satisfy these new requirements? What types of collateral will be allowed to satisfy the requirements – currency, debt, equity, other? • As in the case of HQLA and LCR the question is both important and (more) difficult to answer with precision • Specifically, forecasting how derivative markets will evolve in light of significant new regulation is very difficult

14. Derivative Reform: Initial Margin Requirements • Initial Margin (IM) on cleared derivatives has been estimated to be $420 billion • IM on non-cleared derivatives has been estimated to be $810 billion • Taken together the total amount of collateral required by derivative market reform is similar to that required by the LCR , e.g. $1.2 vs. $1.6 trillion • Since banks and derivative market participants will be competing for collateral it is important to think about where and how this collateral will be sourced

15. The Supply of High Quality Collateral • LCR and derivative market reform may require roughly $3.0 trillion in high quality liquid assets to be held or “locked up” • Is this a large or small increase in the overall supply of such assets? • The CGFS estimated, in 2012, that the supply of HQLA ranged between $48 and $53 trillion. • Incremental demand from LCR and derivative regulation represents less then 10% of the outstanding stock

16. The Supply of High Quality Collateral • Also, this static analysis does not capture the new incentives that will be created, at the margin to “produce” more HQLA • “In the long run supply catches up with demand” • JP Morgan research report argues that “the universe of AAA/AA bonds is actually growing in absolute terms….We expect around $1 trillion of extra AAA/AA bond supply a year over the coming years.. ”

17. Managing the Transition • Regardless of the looseness/tightness of liquid asset demand-supply, one should not take these changes lightly • Both bank and derivative liquidity requirements represent fundamental changes to the financial system • It is not yet clear exactly how markets will respond to these changes – what financial innovations will be used to respond to these requirements, e.g. collateral transformation • Regulators and financial stability authorities should closely monitor these markets and developments to ensure a smooth transition to the new framework and spot potential problems early

18. Conclusion • The financial crisis saw a drastic “run on liquidity” that had severe economic consequences • Global regulators have responded by designing robust liquidity standards in the banking and “shadow banking” sectors. • The requirements may increase demand for high quality liquid assets by as much as $3.0 trillion over the next few years • While the requirements are substantial, existing supplies of liquid assets are significant and expected to grow • Regardless, regulators and financial stability authorities need to monitor the financial system closely as markets respond and adapt to these new requirements to ensure that the intended benefits are realized in practice