In recent months, there has been a welter of speculation about how many toxic assets are sitting in eurozone banks. Now, however, investors face another challenge: working out how many good assets those banks hold on their balance sheets.
The reason? As the eurozone woes worsen, some politicians hope that the European Central Bank might support the banks again via another long-term repo operation (the process by which banks receive money by offering their assets as security.) But there is a catch: even if the ECB does another LTRO, this will only work if the banks have decent collateral to swap for funds. And some observers fear they are running low.
Last month, for example, Ray Dalio, head of Bridgewater Capital, the world’s largest hedge fund, warned his clients that "Spanish banks’ collateral is running out”. Like a cash-strapped household, which has pawned all its jewellery, these banks have already pledged away their valuable assets, he claims. Similar concerns are being muttered about other periphery banks. And though it is difficult to know whether such fears are justified, since public data are thin, investors would do well to watch the issue closely; and not just for the sake of the eurozone, but also because it casts the spotlight on a much bigger issue of collateral across the banking world.
After all, one of the features of the credit boom, and the decades that preceded it, was that investors, policy makers and bankers used to rarely discuss collateral matters. That was partly because the quality of collateral used to be taken on trust; assets marked AAA were assumed to be safe. But there was also a more subtle point: ever since the western world abandoned the gold standard, there has been a stealthy shift away from the idea that financial transactions needed to be secured on tangible assets. Creating credit flows or deals with the click of a computer button became the norm.
Hence the fact that Libor, which measures unsecured lending rates, became the main benchmark for loans. And even when the banks did make secured transactions, the task of managing and valuing collateral was typically handed to low-level, low-paid back-office staff.
Unsurprisingly, practices in the repo and loan market became sloppy, as assets were pledged and repledged numerous times, to generate credit flows. And in the derivatives sector, there was another, pernicious twist: though private sector banks usually posted collateral for deals, public sector entities did not.
"Sovereigns are generally regarded as low risk counterparties and as such have not generally been required to provide collateral,” observes Jai Arya, of BNY Mellon.
This helped to create an under-collateralisation gap in the derivatives world of about $2000 billion, according to estimates from the Tabb group. But while bankers and policy makers used to be willing to ignore such gaps, the last five years have provided a brutal wake-up call. And so, belatedly, a move is now under way to focus on collateral issues again. Western central banks are hiring consultants to assess the collateral they hold. Regulators are pushing derivatives activity on to central clearing platforms, which will force banks to post more collateral, on a standardised basis. Transparency is belatedly coming to the private sector repo markets; last week, for example, Fitch Ratings released one of the most detailed analyses seen to date on collateral in the tri-party repo sector.
Some public entities, such as the Bank of England, have started posting collateral in their own derivatives deals too. And the top managers of private sector banks are now actively engaged. This is partly for defensive reasons. However, it also reflects another key trend: precisely because collateral standards have been so inconsistent, banks can sometimes make money by handling their collateral more cleverly than their clients. Indeed, traders say that "collateral arbitrage” is now a key profit source for some bank desks.
In the long run, this focus is undoubtedly a good thing. After all, a financial system in which transactions are secured on assets is likely to be a healthier system than one which is largely – or patchily – unsecured; particularly if that collateral is valued in a regular, disciplined basis. But in the short term, there is a crucial rub: as collateral practices are tightened, this could impede credit creation. Plugging that $2000 billion gap in the derivatives sector, for example, will be very tough, warns Manmohan Singh, of the International Monetary Fund; indeed, the collateral tightening measures that banks have already taken have created a "second deleveraging”, he argues.
And for the eurozone banks, such as the Spanish, the squeeze is doubly intense. A few years ago, the ECB used to treat Greek and German bonds equally in its repo operations. Now, however, it differentiates between them – and faces pressure from the German and Finnish governments to tighten its collateral standards more. It is unclear whether the ECB will do that; some observers think the ECB is more likely to loosen, not tighten, standards to help the banks. But the one thing that is clear, whatever the ECB does now, is that markets will be watching closely. Collateral issues, in other words, are no longer for back office geeks. Even, or especially, in a world of cyber finance.
Copyright The Financial Times Limited 2012.