THE ASSETS MADE COMBUSTIBLE WHEN REGULATORS CALL THEM "SAFE" / THE FINANCIAL TIMES COMMENT & ANALYSIS

June 1, 2015 6:21 pm

The assets made combustible when regulators call them ‘safe’

Avinash Persaud

The impulse to usher banks on to firm ground is easy to understand, writes Avinash Persaud

 

Exotic assets, and the crippling losses that big and indispensable financial institutions suffered after buying too many of them, bore much of the blame for the last financial crisis. The next one might have a more paradoxical cause. Instead of being overexposed to assets of dubious provenance, many of the same institutions may be buying too many of the assets that the authorities deem safe.

They have no choice. Determined to prevent a repetition of the crisis, regulators are forcing the holders of $100tn worth of assets the world over to buy debt from the most creditworthy issuers: companies and sovereigns with pristine credit histories, which comfortably generate enough cash to cover their obligations. After so many banks were sucked down by doubtful debt lurking deep within their portfolios, the impulse to usher them on to firm ground is easy to understand. But corralling a huge amount of capital into a narrow band of the market drives prices to perilous highs. Even if these assets were safe to start with, the enforced concentration is enough to make them risky.

Consider the Solvency II directive, which is intended to reduce the risk of an EU insurer becoming insolvent, and requires every such institution to hold a proportion of its assets in cash (or cash equivalents). Precisely what proportion depends on how safe regulators believe its other assets to be.

 

Equities are deemed especially risky; insurers are required to put up cash amounting to 28 per cent of the value of their holdings, to guard against the chance that the shares will fall. Short-term bonds issued by companies with high credit ratings are deemed far less risky, and require cash holdings of just 3 per cent. Sovereign government bonds sometimes incur no cash requirement at all.

 

Insurers are just the latest to face such regulations. Similar rules have been imposed on banks.

Regulators require clearing houses and other intermediaries to hold more collateral than before — and it is the same small set of assets that count as collateral.

Meanwhile, central banks in Britain, the US, Japan and now the eurozone have all conducted programmes of quantitative easing, intervening in markets to buy assets using freshly minted cash. In each case, they have favoured sovereign bonds. At the same time as regulated companies are being forced to buy these “safe” assets, then monetary authorities have been taking away large swaths of supply.
 

The result is unprecedented: in the world’s bond markets, almost €5tn of assets currently trade at prices so high that the yields on them are negative, according to data from Thomson Reuters.

Among them are government bonds issued by Germany, the Netherlands, Switzerland, Austria, Sweden and Denmark, as well as some corporate bonds, such as those issued by BP and Nestlé.

Longer-dated bonds issued by European governments also attract low yields; as low as 0.077 per cent, in the case of 10-year bonds issued by the German government.

 

Many observers argue that this is merely a temporary triumph of optimism. No one would buy bonds with yields near zero (or even lower) if they thought there was any prospect of inflation, unfavourable currency fluctuation, or anything else that might erode their value in the next five years. The exuberance will soon pass, these observers say, and yields will return to normal. It is an argument that would have merit if investors were acting voluntarily. But in many cases, their hands are being forced.

You can define particular assets as “safe”, but you cannot wish away the list of economic and political contingencies that might some day cause large numbers of investors to dump them. If oil prices rise again, some borrowers will look less credit worthy. If one government defaults, investors might re-evaluate others. Serious doubts could return over the integrity of the eurozone.

These assets are now so overvalued that they have little chance of rising further. What they do have is a lot of downside, and a lot of jittery holders. Speculators feed off such asymmetries.

That may be why, in just 17 trading days between 20 April and 13 May, low-yielding bonds lost $0.5tn of their value. There was a similarly sharp sell-off last December; then the focus was US government bonds.

These are tremors before the quake. Yet systemically important institutions are being forced to linger on the faultline.

In the popular narrative, the financial crisis was caused by the wilful wrongdoing of the banks. Regulators should know better. In financial markets, risky behaviour is less often born of recklessness than of a false sense of safety.


The author is non-resident senior fellow of the Peterson Institute and Emeritus Professor of Gresham College in the UK