Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.

If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.

Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.

Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.

Weaning the banks off the Old Lady's teat

There is a warm sense of security that comes from suckling liquidity from the teat of the central bank rather than foraging for capital and earnings in a harsh world full of threats and predators. Nonetheless, there comes a time when a good mother pushes away her importunate young and forces them to fend for themselves subject to her stern guidance and supervision.

Central banks have been suckling their broods of commercial banks since the credit crunch first exploded on the scene in August 2007. Now there are signs that the Bank of England and European Central Bank, at least, are keen to push their broods toward self-sufficiency, even at the risk that not all survive independently.

The Old Lady of Threadneedle Street has announced that she really, really means it when she says that the Special Liquidity Scheme introduced to enable banks to draw her gilts against mortgage-backed collateral will be closed down 20th October. The SLS was opened as a “one-off operation with a finite life” and was never intended to do more than bridge the liquidity gap created by the collapse of the mortgage-back securities market while banks adjusted their business models to changed market conditions.

The banks, led by UBS, are throwing temper tantrums, stamping their little feet, screaming in the financial press, but so far the Old Lady is holding firm. Mervyn King said last month:

"The SLS was introduced as a measure to deal with a legacy problem of liquidity of the stock of assets which banks owned last year when the crisis hit. So that window will close in October. The longer-term issue of tightening of credit conditions is much wider. That is to do with the health of the capital position of the banking system, and it's very important not to confuse the two".

Mr King’s determination to husband what remains of the Old Lady’s resources may have something to do with profligate abuse of them when opened to her brood. What started out as a scheme to extend up to £50 billion (a bit less than $100 million) in liquidity to shore up the UK credit markets during a surprise credit dislocation may have been drawn for as much as £200 billion in total as crunch turned to constriction. The Bank will only publish the true scale in October after the SLS closes. The SLS has been hungrily drained by banks keen to swap whatever unmarketable dross remained on their books for good central bank gilts.

The abuse has been made plain in numbers reported by the BIS.

Banks issued a record £45bn in mortgage-backed bonds in the three months to the end of June - more even than at the very height of the housing boom in 2006 - according to figures from the Bank for International Settlements. . . . . The Quarterly Review added: "Most of the UK issuance followed the Bank of England's announcement in April 2008 of a Special Liquidity Scheme (SLS) that enables UK banks to swap illiquid assets such as mortgage-backed securities against UK Treasury bills."

This record mortgage-backed issuance comes at a time when new mortgage lending in the UK has contracted very sharply, down 71 percent year on year for the month of July. That indicates a cynical abuse of the Old Lady’s generosity. Rather than be left with dry dugs dangling to her waist, the Old Lady would prefer to wean the banks while she retains ample bosom and sufficient other assets to shore up her public stature.

Over at the European Central Bank, a rule change this week will increase haircuts (discounts to stated market value) for collateral provided under that liquidity scheme from next February. The ECB has made available over EUR 367 billion (a bit less than $700 billion) under very liberal terms.

According the Financial Times:

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks ... Not in­significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

The normally politic Yves Mersch made explicit reference in his remarks to "dangers of gaming the system".

Nonetheless, with house purchases falling to new lows and credit getting progressively tighter, the Labour government and the Council of Mortgage Lenders are wild to have another source of cheap liquidity if the Old Lady denies them. A new scheme for taxpayer-subsidised mortgage finance is in the offing. It is clearly bad public policy to have the government subsidise further borrowing for the housing sector after such a destructive bubble, but the scale of vested interest and the unpopularity of the Labour incumbents as the house prices fall make a new scheme a certainty all the same.

Rather like a mother who loves her young no matter how ill-bred, destructive and abusive they are to their peers or the community, the Old Lady of Threadneedle Street is unlikely to mind very much if British banks prosper by depredations on the politicians, taxpayers, market counterparties, corporate treasurers, hedge funds and others so long as they are out of the house. Having proved they have no sense of gratitude or duty to the Old Lady that preserved them in time of need, the others who will become their new targets can expect even less consideration.