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
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.
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”
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)
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
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.
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”)
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
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
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
The Role of Derivatives in the Financial System
1.6
800
1.2
600
0.8
400
0.4
200
0.0
0
Outstanding Derivatives
(Trillion USD)
Outstanding CDO (Trillion
USD)
Global Derivative Notional Outstanding
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Year
Source : SIFMA, BIS
 Derivatives are an important and growing source of
liquidity and funding to the financial system
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…..
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
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
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
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.. ”
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
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