There are signs of liquidity decline and liquidity illusion in euro area government bond markets. Citibank research suggests that liquidity risk is rising due to increased capital requirements for dealers, reduced market maker inventories, enhanced dealer transparency rules, elevated assets under management of bond funds, and the liquidity transformation provided by these funds.
A new CGFS paper suggests that bank regulatory capital and liquidity changes may [i] reduce liquidity in money markets, [ii] create steeper short-term yield curves, [iii] weaken bank arbitrage activity, and [iv] increase reliance on central bank intermediation. Profit opportunities may arise for non-banks.
The new European insurance regulation will be introduced in 2016 with important consequences for the global financial system. A paper by Avinash Persaud argues that Solvency II introduces an undue bias against assets with high market and liquidity risk, such as equity. Meanwhile it encourages excessive holdings of low-yielding sovereign and high-grade bonds. (more…)
A new CGFS study suggests that [i] bond market makers’ risk tolerance and warehousing have declined and [ii] tighter risk management has augmented pro-cyclicality of liquidity. A gap seems to have opened between more precarious liquidity supply and more voracious liquidity demand, due to rising assets under management at funds that allow daily redemptions.
Financial regulatory tightening implies to some extent mutation of systemic risk. Thus, elevated bank capital requirements raise incentives for regulatory arbitrage and shadow banking. Liquidity regulation and OTC derivatives reform inflate holdings of government securities and help accommodating high public debt. And the emergence of central banks financial stability mandates and macroprudential policies may create misplaced confidence in crude and untested macro management tools.
The “net stable funding ratio” is a quantitative liquidity standard for regulated banks, scheduled to go into effect in 2018. It will require stable funding sources to be equal or exceed illiquid assets. It may to some degree restrict term transformation of regulated banks and encourage migration into shadow banking. The impact of the new regulation will differ across countries and institutions.
The Basel III capital regulation reforms introduced a non-risk based leverage ratio for banks. A new ECB paper shows that a leverage ratio requirement may have unintended negative consequences. It encourages banks that specialize on low-risk lending to raise their share of high-risk loans. And it could make overall bank portfolios more similar, increasing the contamination risk from negative surprises to expected default risks.
From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.
The OTC derivatives reform is nearing completion. It is designed to contain derivatives-related credit and contagion risk through standardization, multilateral netting, and adequate collateralization. However, new risks may arise, due to the enhanced importance of a small group of global banks, institutional weaknesses of central counterparties, limited collateral availability, and cyclicality of margins,
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
