Financial journalists have a difficult job. This is particularly true when they are commenting on markets. These are complex, subtle and dynamic systems which journalists have to observe from the outside. Their problems are usually compounded by lack any direct experience of markets and a paucity of professional or academic literature to consult. If journalists turn to market sources, they have to be wary of possible conflicts of interest. And one hopes that journalists recognise their own conflicts of interest: they are under pressure to produce sensational stories.
These challenges mean that there is a risk of poorly briefed and confused journalists conjuring up articles that inflict damage on markets by encouraging poorly briefed and confused politicians to impose regulations that undermine the ability of markets to perform their essential functions. The consequences can be very real: higher financing costs to the economy and loss of livelihood by those working in finance. The risk is magnified where a journalist is leveraging the reputation of an influential financial newspaper like the FT.
An article that raised concerns appeared in the FT in November, penned by the respected financial journalist Patrick Jenkins. It was entitled “Regulators’ boost for securities lending has risky implications: banks use ultra-safe bonds as compliance shortcut”. It was a strongly-worded attack on securities lending and its role in collateral transformation, which is the process of acquiring higher-grade collateral by giving lower-grade collateral in a temporary exchange. The firm doing the upgrading will typically be doing so because, in the normal course of its business, it does not the type of collateral required by counterparties such as CCPs.
Jenkins dramatically accuses banks of going to “extravagant lengths” to “window dress” and “prettify” their end-year balance sheets. “What are they trying to hide?” he asks, given that securities lending is “probably best known as a proxy for hedge fund aggression because the short selling of equities relies on trading borrowed stock”. For Jenkins, it is “yet another example of the backdoor transfer of risk out of banks and into other parts of the financial system — namely the lightly regulated realm of shadow banking — which we may one day come to rue”.
And Jenkins argues that the securities lending industry has form when it comes to dodgy deals, as “only a few years ago, trades, particularly in Europe, were spurred by a tax avoidance wheeze…cross-border dividend payments used to attract punitive tax charges, but if equities were swapped with a domestic shareholder, such as a bank, the liability evaporated”.
What is being hidden, according to Jenkins, is that “banks are bringing German Bunds, US Treasuries and UK gilts on to their balance sheets, and getting shot of riskier equities by posting them as collateral”. And this business is booming because “policymakers have unwittingly created a new supply-demand dynamic”.
Jenkins’ new dynamic is “new rules on bank capital, liquidity and the clearing of derivatives transactions”. He argues that “there is a three-way regulatory arbitrage at play” in which:
- “banks are boosting their liquid assets to comply with the new Basel III requirement known as the liquidity coverage ratio.”
- “The second trick is that the exchange of assets can be a boon to capital, with equities that tend to attract higher capital weightings swapped for “risk-free” bonds.”
- And thirdly, “with so much derivatives trading moving to central counterparty clearing, there is increasing demand for high quality assets to be used as collateral…and for that, government bonds — even borrowed ones — avoid punitive haircuts imposed on some equities”.
Jenkins skilfully manages to line up topical buzzwords for his article’s word cloud: hedge funds, shadow banking, tax avoidance and regulatory arbitrage.
So, what is wrong with Jenkins’ article?
He was absolutely correct to say that banks are upgrading their collateral. Banks need a stock of so-called High Quality Liquid Assets (HQLA) to meet their Liquidity Coverage Ratio (LCR). In other words, banks need sufficient HQLA to sell or repo out to raise cash to fund a projected net outflow during a severe 30-day market crisis. But why are collateral upgrade trades a problem? If your underlying business does not always generate enough HQLA and you do not permanently need more, it is entirely logical to borrow it through a collateral swap. And, if you are going to borrow to cover a 30-day period, it is perfectly sensible to borrow for that sort of period. It would be risky to borrow for one day and have to roll over.
As for swapping from equities to government bonds, Jenkins seems to have been misled by the ISLA survey to which he refers. This does not say that 90% of European government bond lending is against equity collateral. Rather, it says 90% of European government bond lending is against non-cash collateral. While the report suggests that “This supports very much the view that borrowers in securing access to HQLA are almost exclusively optimising balance sheet and risk weighted assets by providing other assets, often equities, as collateral in these transactions”, there is no hard evidence.
But, even if lots of equity is being swapped for HQLA, what’s the problem? Equity has little value for meeting the LCR. Common equity only counts as a Level 2B HQLA, which means it is only eligible if the national regulator permits and, even if it is permitted, is hit with a minimum 50% haircut and is subject to a 15% concentration limit. Moreover, most CCPs do not accept equity at all as collateral. If a collateral swap can extract some collateral value from equity holdings, it is sensible for a well-managed bank to consider doing so.
Perhaps the most serious mistake in the FT article is about the impact of securities borrowing on balance sheets and risk-weighted regulatory capital charges. Contrary to what the article says, borrowed securities do not come onto a borrower’s balance sheet and the borrower does not pay the capital charge on borrowed securities. This is because the risk and return on borrowed securities is retained, if only indirectly, by the lender. For the same reason, the collateral given in exchange for borrowed securities does not leave the balance sheet of the borrower and he continues to pay the capital charge on these securities. So the borrower cannot use a collateral swap to reduce his capital charge by borrowing HQLA against lower-grade collateral. Indeed, the capital charge of the borrower will increase given that he is taking risk by giving collateral to the lender. There is nothing being hidden here.
For the record, borrowing securities will also not help improve the other liquidity ratio introduced to complement the LCR, namely, the Net Stable Funding Ratio (NSFR). The NSFR, which is designed to enforce a stable asset/liability structure, basically follows balance sheet treatment, ie borrowed assets do not appear on the balance sheet of the borrower, while the collateral given does not leave the borrower’s balance sheet.
Nor will borrowing securities yield any advantage under the Leverage Ratio, arguably the tightest regulatory constraint on banks.
It is a pity that the FT article skates over the fact that securities loans are over-collateralised and margined, and that lenders are very counterparty-sensitive, which means there is typically little risk to lenders. And then there is the visceral reaction to short-selling. This can be destructive but generally it plays a very desirable role in cooling over-valued assets and puncturing price bubbles.
Finally, there is the attack on tax arbitrage. Has this actually been all so evil? Of course, some tax arbitrage was and is unethical. But what is so fair about punitive tax charges on cross-border investors? This was why there have been the “single market rulings to eliminate cross-border withholding taxes” mentioned by Jenkins. It could be argued that markets, once again, played a key role in mitigating unfair and inefficient burdens imposed by protectionist and discriminatory governments until the politicians were forced to catch up.