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Collateral framework: risks and policies

The rising importance of high-quality collateral for financial transactions brings new systemic risks, such as potential collateral shortages and secured funding constraints in crisis times. Vulnerabilities are augmented by collateral optimization, transformation, re-use and re-hypothecation. Collateral policy has become an important part of central banks’ toolkit.

Capel Jeannette (2015), “Central Bank CollaterALL”, De Nederlandsche Bank, Occasional Studies Vol. 13 – 3
http://www.dnb.nl/en/binaries/301122_OS13-3_eng_WEB_tcm47-324019.pdf

The below are excerpts from the paper. Headings, links and cursive text have been added.

Issues and risks of the collateral framework

Collateral shortages

“The Committee on the Global Financial System observes that the collateral adequacy varies markedly across jurisdictions and that in some countries temporary shortages of high-quality collateral may occur…Moreover…there may be individual financial institutions experiencing collateral scarcity…Finally, there may be individual institutions that do not have an issue with the size of their collateral portfolio but with its composition. Such collateral mismatches are quite plausible because of two recent regulatory initiatives: the liquidity coverage ratio (requiring banks to hold strictly defined buffers of high quality liquid assets) and the obligation to clear via central counterparties (CCPs) for standard OTC derivatives contracts (implying that financial institutions need more cash and highly liquid assets to fulfil margin requirements imposed by the CCP).”

Collateral optimization

“Collateral management has become a greater priority for financial institutions… One strategy is collateral optimization, which can be defined as the actions undertaken to make the best possible use of the existing portfolio of collateral assets.”

“Disadvantages of collateral optimization are the risks involved. One consequence of the creation of a central collateral pool out of fragmented collateral ‘pockets’ is that financial institutions may be incentivised to economise on the overall size of their collateral buffers, leading to too low collateral buffers…Another source of risk lies in the interdependencies created, internally (as different departments within the financial institution become dependent on the smooth functioning of a central collateral department) and possibly externally too (if the institution uses the collateral management services of a custodian).”

COL_RISK03

Collateral transformation

“Collateral transformation refers to transactions that are initiated to obtain specific assets for collateral purposes…Collateral transformation is possible for financial institutions with a sufficiently large overall collateral portfolio, but without sufficient assets accepted as collateral by its counterparty (e.g. cash or high-quality government bonds for CCP use). Such an institution can directly enter the repo market or securities lending market to obtain the eligible assets, if it is active in these markets. If not, it may approach a collateral transformation provider (e.g. a bank acting as custodian or general clearing member) to arrange a collateral swap.”

COL_RISK04

Collateral transformation is risky because the availability of collateral upgrades is highly pro-cyclical: easy to obtain in normal times, but potentially impossible or very difficult/expensive during stress…This makes liquidity obtained via collateral transformation an unstable source of liquidity…The maturity mismatch reinforces this: the desired collateral is usually needed for a longer time than the typical maturity of repo and securities lending transactions so that these transactions need to be rolled over.”

Collateral re-use

“Collateral re-use and collateral re-hypothecation refer to cases where financial institutions can use the collateral received from others for their own transactions…The re-use and velocity of collateral act as a ‘collateral multiplier’ The size of the collateral multiplier (cm) depends on the re-use rate (r): cm=1/(1-r). For instance, if in practice 50% of collateral is re-used, assets worth EUR 100 billion could in practice collateralize transactions worth EUR 200 billion.”

On the re-use of collateral and the formation of collateral chains view post here.

“The risks of collateral re-hypothecation are quite similar to those of collateral transformation…Collateral re-hypothecation creates interdependence because the same collateral assets are used to secure transactions by different participants and possible uncertainties can emerge as to whom owns what, creating uncertainties and risks if collateral is recalled or transactions unwound…[It] also leads to liquidity risk. This is amplified by pro-cyclicality: during stress the perception of institutions’ creditworthiness can deteriorate very quickly, leading to a possible withdrawal of re-hypothecation rights and subsequent funding problems at institutions that have fallen out of favour. Problems at one or several institutions may infect the whole system: as collateral velocity decreases, so will market liquidity, which may in extreme cases cause markets to dry up.”

Central bank collateral policies

“Many central banks, including the Eurosystem, need to have a collateral policy since they are not allowed to lend unsecured…Collateralized lending…allows the central bank to lend at the same rate to all counterparties, thereby contributing to a smooth transmission of monetary policy.”

“Central banks nowadays operate in a very different ‘collateral space’ than before the financial crisis…Financial institutions nowadays need much more high-quality collateral, both because of greater risk aversion in financial markets and because of regulatory change such as the new liquidity standards and OTC derivatives markets reforms.”

COL_RISK02

“The financial crisis made clear that ratings from credit rating agencies and collateral haircuts (both in central bank and private transactions) can be very pro-cyclical and strongly affect system-wide leverage…In response to the financial crisis, many central banks have recently broadened their collateral frameworks. Public sector securities were already eligible before the financial crisis at all twelve central banks that participated in the BIS survey, but for all other asset classes (financial entity debt, covered bonds, other asset-backed securities, corporate debt and/ or non-securities) eligibility has been broadened at several central banks.”

“Central banks can influence collateral markets through the so-called scarcity and structural channels.

  • The scarcity channel refers to the impact of central bank operations – via their effect on the available amount of collateral or its composition in the market – on the prices, rates, and price volatility of collateral assets
  • The structural channel refers to the impact central banks could have on the functioning of collateral markets by designating eligible securities, implementing changes in clearing and settlement systems or providing other infrastructure support… The eligibility criteria and risk control measures set by the central bank do not only determine its level of risk protection, but also the amount of central bank eligible collateral that the central bank’s counterparties can provide.”

On the influence of central banks on supply and pledgeability of collateral view post here.

“The collateral footprints of central banks are bound to be (much) larger in crisis times than in normal times. In normal times central banks tend to operate at the margin and on a limited scale…During periods of stress more central bank eligible collateral is needed than in normal times…One reason is the higher demand for collateral during stress: financial institutions typically need both more central bank liquidity (as funding through the interbank market becomes more difficult) and more collateral to secure their transactions with other market participants (who tend to set stricter collateral requirements)…
Central banks tend to play a more significant role in collateral markets, both intentionally (e.g. central banks may decide to influence the functioning of collateral markets by broadening their collateral frameworks) and unintentionally (e.g. the much larger scale of their operations could have unintended side effects on collateral markets that have to be managed).”

COL_RISK01

“Faced with a shortage of high-quality assets in the market or in its capacity as lender of last resort, a central bank may decide to accept assets that are unacceptable as collateral in other circumstances, including assets with a credit quality below the minimum level…in practice central banks have been willing to provide emergency liquidity assistance to solvent but illiquid banks against a wide range of valuable collateral assets that are not acceptable in normal circumstances – in some cases even buildings and paintings.”

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