Joachim Nagel: How market segments changed over the crisis -
challenges for future banking
Speech by Dr Joachim Nagel, Member of the Executive Board of the Deutsche Bundesbank,
at the ESE (the European Supervisor Education initiative) Conference 2013 "The future of
European financial supervision", Frankfurt am Main, 26 September 2013.
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1. Introduction
Ladies and Gentlemen
I am delighted to be speaking at this year's European Supervisor Education (ESE)
Conference. The idea of the ESE initiative is to bring together the experiences of
practitioners and the theoretical knowledge of academic researchers. The Bundesbank has
always considered this to be an important issue and has, as a founder member, supported
this initiative from the beginning.
As most of you are experts in banking supervision, I will not try to tell you anything new about
the recent regulatory changes. Instead, my focus will lie on the changing market conditions
- partly triggered by new regulations - and their impact on banking, especially bank funding.
The challenges currently facing the European banking sector are reflected in the remarkable
changes in the refinancing pattern of European banks on the capital and interbank money
markets. As a central banker, I have a special interest in developments in the money
markets, so this will be my first main topic. Subsequently, I will discuss some regulatory
aspects such as the Liquidity Coverage Ratio and its possible impact on capital markets.
Thereafter, I would like to describe some changes in the repo market and the ongoing trend
towards clearing via central counterparties, followed by a discussion of developments in the
market for covered assets. Before I summarise, I will cover the sovereign bond market.
2. Money market conditions before and since the financial crisis
Up until 2007, the euro interbank money markets were characterised by small counterparty
risk premia and highly liquid markets. Risk aversion was low, and there was significant trust
in, and among, banks. As a consequence of the financial crisis and the sudden loss of
confidence between counterparties, overall turnovers in the euro money market declined
significantly, especially in the unsecured segment. Even today, unsecured trading in
maturities longer than three months is very rare. At the same time, the importance of secured
market activity has increased, reflecting heightened concerns about counterparty risk. At the
current juncture, turnover in the secured segment is more than three times higher than in the
unsecured segment. Secured trading can limit credit risk, as the lender will suffer a loss only
if the counterparty and the pledged collateral default simultaneously. As limiting credit risk
has become a fundamental concern during the crisis, importance is increasingly being
attached to the liquidity of collateral markets and the associated collateral pricing.
The growing share of secured trading via electronic trading platforms can be explained
mainly by the increased turnover in the secured segment. These platforms offer clearing
services through central counterparties (CCPs). CCPs limit counterparty credit risk and
mitigate information asymmetry within the market. As the CCP guarantees the transaction
and defines quality standards for both, participants and the accepted collateral, information
about the individual counterparties becomes less important. By acting as an intermediary
between the trading partners, the CCP enables them to trade anonymously on these
platforms. This helped stressed market participants from peripheral countries to access the
collateralised money market throughout the crisis. In spite of these positive effects, the
increasing importance of CCPs harbours the risk of contagion effects. The default of one of
these central and highly connected interbank participants might have serious impacts on
markets.
The uncertainty involved with transactions between banks of different countries has another
consequence. The Eurosystem has become the most important counterparty in the euro
money market. Before the first tensions were felt, the Eurosystem generally ensured broadly
balanced liquidity conditions. Credit institutions on aggregate were allotted as much liquidity
as was needed under given autonomous factors. With the full allotment policy, liquidity
provision increased sharply. As a consequence of very low market rates relative to the
deposit facility and amid concerns over the credit quality of counterparties, a clear preference
emerged for storing liquidity on central bank accounts rather than lending it in the interbank
market. In short, liquidity flows between banks were much smaller than before the crisis.
The Eurosystem's central intermediary role became even more evident when it started to
supply long-term liquidity via one-year and three-year longer-term refinancing operations
(LTROs). The three-year LTROs were introduced to support bank lending. Furthermore, they
eased tensions in the sovereign bond markets of the peripheral countries, as banks
intensified their government bond purchases. However, we have observed a strong
preference on the part of banks to buy bonds issued by their home countries. This amplified
the interdependence of the banking sector and the domestic sovereign bond market in
certain euro-area countries and aggravated the existing geographical segmentation.
The geographical segmentation is reflected in European banks' reliance on Eurosystem
refinancing. After the Lehman insolvency, this reliance initially increased in most countries as
risk aversion rose. Later, segmentation developed differently across countries, reflecting the
perceived riskiness of each country. More recently, the Eurosystem policy to mitigate market
segmentation and to safeguard an appropriate monetary policy transmission, namely by
announcing Outright Monetary Transactions (OMTs), is mirrored in reduced country
differences. But this is no justification for the OMTs. It has eased market tensions, especially
redomination risk. Nonetheless, the Bundesbank's concerns are still extremely relevant.
Country differences regarding the reliance on Eurosystem refinancing remain large, as
indicated by the share of banks' balance sheets that is financed by Eurosystem liquidity. This
has also become obvious in the structure of early repayments of the three-year LTROs. It
has mainly been banks located in the core countries that have reduced outstanding volumes.
Furthermore, the reliance on national counterparties has increased. Over the last few years,
euro-area cross-border activity has declined constantly.
3. Regulatory changes as reaction to the crisis and their impact on market
structure and banking
The experience of the recent financial crisis has triggered regulatory changes, especially in
the banking sector. The new Basel III banking standards will address some of the root
causes of the financial crisis and aim to prevent another build-up of liquidity and solvency
risks. The Basel III framework for liquidity risk regulation encompasses two ratios - the
Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Both will have an
impact on how banks manage their business activities. As the LCR will be introduced earlier
and the details are far more developed, I will discuss its impact on euro money markets.
However, the LCR might yet be revised before its final implementation.
With regard to the assets side of a bank's balance sheet, a bank will primarily purchase High
Quality Liquid Assets (HQLA) to improve LCR compliance. Holding these assets outright will
improve the LCR. Demand for these assets is likely to increase, potentially causing them to
trade at a premium. This regulatory-driven additional demand might reduce appetite for
lower-quality liquid assets.
Turning to the liabilities side, banks with an LCR of below one will need to substitute
shortterm for longer-term funding. This could reduce the volume in the short-term unsecured
interbank market, though banks will probably continue to engage in significant short-term
unsecured trading for daily liquidity management purposes, as they will still need to fulfil
reserve requirements. Central banks will have to monitor the impact the new liquidity
regulations have on monetary policy implementation.
Unlike interbank funding, central bank refinancing over a 30-day horizon would not count as
an outflow in the LCR, as it always benefits from a 100% rollover rate. This could increase
demand for central bank refinancing. If non-HQLA are used as collateral, there would be no
reduction in the numerator and, therefore, the LCR would rise. Banks may therefore choose
to boost their cash reserves at the central bank (which count as HQLA) by increasing their
central bank refinancing that is backed with non-HQLA as collateral. While this also depends
on the opportunity cost of obtaining liquidity from the Eurosystem, there may be a number of
banks with large amounts of collateral that is not classified as liquid under Basel III but that is
eligible for monetary policy operations.
However, the interaction of LCR with monetary policy operations and the money markets has
been acknowledged. In January 2013, changes to the LCR were announced. In particular,
the timetable for fully phasing in the LCR requirement has been extended from 2015 to 2019.
Additionally, the list of HQLA has been broadened and punctual recalibration of the net cash
outflows will give banks more time to recover from the crisis and to implement the LCR in a
more orderly manner. This will likely reduce the level of market fragmentation that might
otherwise have arisen had all banks had to meet the LCR 100% requirement by 2015.
In general, Basel III is the right answer to the lessons learned from the crisis. Nonetheless,
its impact on market patterns and banking behaviour has to be monitored carefully to prevent
undesirable developments.
4. Repo market
The net impact on a bank's liquidity position of increasing its level of repo funding is
somewhat more complex, but overall it tends to improve the LCR and encourages a greater
level of secured funding, irrespective of duration. However, the higher demand for good and
liquid assets may reduce the supply for repo markets - potentially reducing liquidity in the
secured repo markets and adding to market volatility, particularly in times of stress.
Secured transactions, especially transactions via CCPs, have reanimated the money market
in times of high uncertainty. This is also reflected in the fact that the share of international
counterparties on trading platforms such as GC Pooling increased during the crisis. One
reason is that it became apparent during the financial crisis that big and well-established
counterparties, too, can become illiquid or insolvent. Under these circumstances,
collateralisation has become more important. However, there is a growing gap: the
importance of collateral quality has risen sharply, and at the same time, high quality and
liquid collateral is becoming a limiting factor. Furthermore, the ability to increase debt funding
through repo transactions will also be limited by regulatory changes in the future.
Additionally, the ample liquidity provided by the Eurosystem, especially via the two three-year
LTROs, together with the enlarged collateral framework for Eurosystem refinancing has led
to reduced activity in this market segment, too. The decisive question for market participants
now is whether the Eurosystem will stick to or reduce its non-standard monetary policy
measures such as the full allotment policy and the enlarged collateral framework.
Given declining excess liquidity related, in particular, to the early repayments of the
threeyear LTROs, new business models may arise in the medium term as banks' funding needs
will pick up again. It is therefore up to market participants to find a new balance between
risks and benefits in relation to cross-border lending.
Furthermore, the importance of banks' collateral management will be further enhanced as a
consequence of the crisis. Credit institutions should aim to manage their collateral more
efficiently without taking on additional risks. CCPs and the use of trading platforms can
contribute to this.
Another important factor on the repo market of the future will be the planned financial
transaction tax (FTT). In its current design, it may harm the short-term repo market segment,
as even a low tax rate of 0.1% for trading a sovereign bond represents a high burden to
short-term and revolving repo transactions. To illustrate the problem, I would like to give you
an example: for an over-night repo transaction with a current interest rate of 0.04% and a
volume of EUR 10 million, a total of EUR 10,011 (ie EUR 11 in interest and EUR 10.000 in
FTT) has to be paid. The tax-free use of the marginal lending facility of the Eurosystem
involves a payment of EUR 278 in interest. Funding via the repo market would be 36-times
more expensive than central bank refinancing. Such a financial transaction tax would
probably reduce repo market activity and encourage Eurosystem refinancing. That is not
desirable.
5. Market for covered assets
Turning to longer-term funding instruments, I would first like to mention that EU banks' total
issuance of debt funding dropped by 12% year on year in the first half of 2013 to its lowest
level since 2002. Besides the ample liquidity provided by the Eurosystem, which reduces
banks' demand for additional funding, the regulatory changes resulted in banks seeking to
reduce their reliance on wholesale funding in favour of deposits from retail and small
business customers. The decrease in borrowing also reflects pressures facing banks, such
as the need for smaller, more robust balance sheets, and concerns among investors about
"bail-in" rules. Consequently, banks may face higher funding costs as investors demand
more compensation for the increased risk of losing their money.
In addition, higher asset encumbrance has an impact on unsecured bank creditors. The more
bank assets are used for secured funding, the less remain to secure investors in unsecured
instruments in the case of insolvency. They will price in a risk premium for this form of bank
funding.
As in the money market, we observe fragmentation between core and peripheral countries in
Europe. The perceived risk of financial sectors in the periphery and in the core euro area
started to diverge back in 2010 when the financial crisis turned into a sovereign debt crisis.
Still, the individual quality of banks' balance sheets influences investment decisions
significantly. Banks located in peripheral countries have reduced their issuance to a higher
degree. Developments in their home economies have stressed their balance sheets, namely
by the share of non-performing-loans. Furthermore, the nexus of sovereign and financial
sector credit risks has made funding a lot more expensive, if not impossible, for them.
Therefore many of these banks are still highly dependent on Eurosystem funding.
The lower demand has also made itself felt in the volumes of secured instruments issued,
although markets have, since the crisis, displayed a preference for secured funding.
Covered bond issuance volumes declined given an ample liquidity supply by the Eurosystem
and a tendency towards balance-sheet deleveraging. In the first seven months of 2013, the
volume of newly issued covered bonds denominated in euro decreased by 38%. Issuance
volume has therefore reached its lowest level since 2009. Given that the volume of matured
Covered bonds significantly exceeds issues, the resulting excess demand has narrowed
covered bond spreads against Bunds. The US tapering discussion, which started at the end
of May, led to a widening of spreads, especially of peripheral issuers. The overall
improvement in market sentiment regarding the European sovereign debt crisis has enabled
banks located in peripheral countries to step up issuance. The share of issues with volumes
of between EUR 500 million and EUR 1 billion, so called "mini-Jumbos", has grown. This
development can be attributed to the growing importance of better asset-liability
management as a result of regulatory changes that require, amongst others, a better maturity
match.
Another secured funding market, the ABS market, is still suffering from the financial crisis,
which was partly caused by its own excessive developments. Therefore, the stricter
regulatory rules regarding ABS are important to prevent similar developments in the future.
However, we should bear in mind that the ABS market is quite heterogeneous. "Plain vanilla"
ABS backed by high-quality assets are fairly safe investments which have wrongly got a bad
reputation. To increase investor confidence, the Eurosystem has supported the ABS market
by promoting the "Loan Level Data Initiative", which has significantly improved transparency
regarding underlying assets. In turn, this has allowed the Eurosystem to relax collateral
requirements for ABS recently.
ABS are one the most prominent asset classes used as collateral for Eurosystem refinancing
operations. However, recently, covered bonds and government bonds have gained
importance. Nearly half of ABS issues were placed publicly in the first half of 2013 compared
to one-third in the second half of 2012. This shows some improvement in this market.
Spreads on the secondary market have also narrowed significantly in the last 12 months.
However, the Portuguese government crisis in June demonstrated that political incidents
influence ABS spreads directly. Although Portugal is a relatively small country, developments
there had a strong impact on the spreads of ABS backed by assets originated by banks from
other peripheral countries, especially Spain.
In terms of the different types of ABS, residential mortgage-backed securities (RMBS) still
represent by far the biggest share of the market. While ABS backed by loans to small and
medium-sized enterprises (SME ABS) represent a sizeable share of the market, many issues
are retained and used directly as collateral for Eurosystem refinancing operations. However,
the Eurosystem believes that SME ABS could and should represent a sizeable source of
bank financing. They could encourage lending to SMEs and foster the transmission of
monetary policy by indirectly easing lending conditions to SMEs. In the press conference
held on 2 May, ECB President Draghi therefore announced a consultation with other
European institutions on "initiatives to promote a functioning market for asset-backed
securities collateralised by loans to non-financial corporations". This statement was further
backed by the announcement on 18 July that the ECB will continue to investigate the
possible acceptance of certain guaranteed mezzanine tranches of SME ABS.
Another structured instrument I would like to mention are contingent convertibles (CoCos),
which could complement banks' various refinancing instruments. As it is a fairly new
instrument with a lot of different arrangements, it is difficult to estimate the exact scope of this
market segment. CoCos are a useful instrument to increase the capital base in times of
stress. They automatically turn into core tier 1 capital if the trigger - mostly the core capital
rate - is undershot. Investors have to be compensated for this extra risk alongside default
risk and subordination risk in case of insolvency. Recently, this additional spread has shrunk
as a consequence of the increased "search for yield" in the low interest rate environment.
Consequently, CoCos may become establish as a funding instrument although they bear the
risk of being converted or even written down to zero.
As I approach the end of my speech, I would like to focus on a market which has changed a
lot during the crisis and also plays a prominent role in central bank politics: the sovereign
bond market.
6. Sovereign bond market
Government bond markets have suffered during the ongoing banking crisis, especially as it
turned into a sovereign debt crisis. They are no longer considered a homogeneous, risk-free
asset class.
Investors' willingness to take risk diminished sharply. Volatility and liquidity became the most
important topics for market participants. Bond buyers exercised greater scrutiny and a series
of rating downgrades prompted investors to re-evaluate their belief that European
government bonds are risk-free assets. This led to a differentiated perception of European
government bonds and diverging yields for the individual countries. To a certain degree, the
increased spreads seem to be justified. They reflect diverging fundamentals in different
countries - ie the different economic situation and levels of public debt. It is questionable
whether the convergence of yields in the years before the crisis reflected the right
assessment of the various risks underlying these investments.
Currently, refinancing conditions for the peripheral countries have improved notably. Hence,
OMT will hopefully never have to be activated.
However, market sentiment can change very quickly. In January 2010, Greece received
offers of about EUR 25 billion for its five-year government bond issue with a volume of
EUR 8 billion. A couple of weeks later, Greece was no longer able to refinance its liabilities
via the capital market. Although there are currently small improvements in GDP growth in
several European countries, the risk of renewed tensions in sovereign debt markets is still
alive given low growth and the slow implementation of reforms on the one hand and the
expected tapering of the Fed's quantitative easing programme on the other hand.
Lower investor confidence, besides sending European government bond yields and CDS
premia higher in the secondary markets, has also impacted the primary markets. The space
left by external creditors was occupied by domestic investors such as banks, who increased
their investments particularly following the introduction of the three-year LTROs.
The trend towards renationalisation is a development that needs to be monitored. It
reinforces the interdependence of the sovereign sector and the domestic banking system.
European banks often only invest in the sovereign bonds of their home countries.
Credit institutions must increase their risk awareness in terms of sovereign bonds. On the
one hand, banks should have credit limits for individual countries. This would reduce
dependencies on certain debtors. On the other hand, these bonds have to be secured by a
sufficient level of equity. In the medium term, government bonds should be treated like
corporate bonds. Experience has taught us that sovereign bonds are not a risk-free asset.
Furthermore, risk-appropriate treatment would lead to increasing yields of countries with
unsound finances. Therefore, market regulation would provide an incentive for fiscal
discipline.
The current initiative to establish an effective Single Supervisory Mechanism is a step in the
right direction. It will help us to identify risks at an earlier stage and is therefore also
important for disentangling the critical link between sovereign and bank funding. However,
the banking union, consisting of a sound Single Supervisory Mechanism and Single
Resolution Mechanism, is a future project to prevent future problems. Existing burdens have
to be treated separately. They arose under national responsibility and should not be
mutualised. Therefore, the planned financial inventory of banks' balance sheets is crucial and
needs a close examination. Banks which do not have a sustainable business model should
not be kept alive with public financial support.
7. Closing remarks
Overall, stress levels in the markets for European government bonds and bank refinancing
have diminished significantly since the summer of 2012. Nevertheless, the question whether
the interbank market will return to its former integrated status remains open. Secured trading
in connection with the use of CCPs may play a crucial role in the changing environment as it
reduces counterparty risk and helps to improve collateral management.
The ongoing repayments of the three-year LTROs reduces excess liquidity in the money
market and could be interpreted as suggesting that market participants no longer need as
much access to central bank liquidity as before. But let me be unequivocal about one thing:
this development has been induced by the markets, it has not been triggered by the
Eurosystem.
Furthermore, banks should focus on achieving a reasonable mix of short-term funding and
refinancing via longer-term repos and bond issues. This could help alleviate the current
tendency of some banks to leave their cash reserves in the ECB's deposit facility rather than
offering them in the interbank market. This would be an important step towards
reestablishing a well-integrated money market in the euro area.
The regulatory steps undertaken with Basel III go in the right direction, but their impact on the
markets has to be carefully considered.
In the banking sector, business models need further adjustments, which should ultimately
result in a more resilient and diversified sector with a more sustainable risk-return profile. In
the current low interest rate environment, it is surely no easy task to increase earnings.
However, developments so far go in the right direction as eg German banks' average equity
base has improved considerably since the beginning of the crisis. For the twenty biggest
credit institutions, the core capital rate has doubled on average.
Nonetheless, the interconnectedness between banks and their home country has to be
monitored closely as it holds a strong contagion risk.
Thank you for your attention.