Reflections of the CEO

In Search of Liquidity in California & Switzerland, & Why Basel May Not be the Answer

The Federal Reserve’s report on Silicon Valley Bank (SVB), published on 28 April, made uncomfortable reading for some. Whilst the report highlighted the failure of SVB due to poor regulatory oversight and internal decision-making, it also described some interesting factors that were clearly at play.

Firstly, and notwithstanding that the reasons behind the failure of SVB and subsequently Credit Suisse (CS) were quite different, at the heart of both there was a sudden and dramatic failure of liquidity. Customers of SVB withdrew nearly a quarter of the bank’s deposits, amounting to $42 billion within a single day in March. This level of withdrawals was not sustainable, especially if the bank had to liquidate its substantial US Treasury portfolio, which would have crystalised significant mark-to-market losses. With many of SVB’s liquid assets held in interest rate-sensitive fixed-income securities, the bank collapsed in as little as 48 hours; the comparison with the queues outside Northern Rock in 2007 now seem to come from another age. The Fed report into the collapse of SVB identified both social media and mobile technology as material factors that led to its rapid demise. On this point, I am immediately reminded of the events around GameStop in 2021, when these very factors drove a series of unexpected outcomes that regulators struggled to keep pace with. Regulators now face the challenge of regulating these new and novel ways of moving liquidity around the financial system that do not conform to previous norms or conventions.

In contrast, CS had been on many commentators’ watchlists for some time. As markets behaved in an almost febrile way following the demise of SVB, many institutions were tested by the markets. Unfortunately, CS was found to be wanting, leading to its ‘arranged marriage’ with UBS.

Over the May Day weekend, it was announced that J.P Morgan is to acquire most of First Republic Bank. In a scenario similar to that around SVB, First Republic saw $100 billion in outflows prompting the US regulators to look for a suitor. Here again, the strain on First Republic’s liquidity appeared unsustainable.

Many risk managers will tell you that liquidity is almost impossible to model – it’s either there or it is not. It is generally accepted that liquidity drives efficient markets, and when it fails for institutions like SVB and CS, or systemically as we saw in 2007/08, its impact can be devastating. In the case of the latter, markets effectively close, demanding regulatory and central interventions.

It is therefore counterintuitive, in my view, that the current Basel/CRD prudential regime making its way through the legislative process both in the UK and in Europe, appears to offer little recognition of the importance of liquidity to the smooth running of financial markets more broadly. At the heart of the Basel IV reforms is the move away from the use of internal models to calculate counterparty risk and resultant Risk Weighted Assets (RWA) exposure, in favour of using the so-called standardised approach. In this regard, the standardised approach looks at risk with unrated counterparts in a very different and potentially penalising way. When investment funds serve as counterparties in securities finance transactions with banks and broker-dealers, they risk being captured as unrated entities under the new rules, and would therefore receive the same capital treatment as unrated corporates under the Basel output floor. As a result, the risk-weighting for securities lending arrangements with funds will rise dramatically for borrowers, disincentivising such activity despite its prudential benefits and market-supporting role.

While we might debate the merits of internal versus standardised credit models, I doubt either would have had a material impact on the outcomes for both SVB and CS. Having said that however, and even if we acknowledge for one moment that there is an argument for a different treatment of unrated counterparts regarding RWA exposure in the context of standardised models, surely you cannot treat highly-regulated UCITS funds in the same way? A well-established and proven regulatory framework that ensures stability for both retail and institutional investors; here, one size that fits all simply does not work. There does, in my view, need to be some sort of differentiation between distinct types of unrated entities, or as we at ISLA have advocated for, a carving out of SFTs from this part of the Basel regime altogether.

As currently drafted, the Basel IV proposals may well make liquidity more expensive, and in the case of unrated mutual funds like UCITS, prohibitively so. As lending supply is potentially drained from the markets, we are likely to see less liquidity in the cash and derivatives markets, leading to wider bid/offer spreads and increased hedging costs. This unintended consequence of the Basel proposals is also at odds with the European Union’s desire to engage retail investors directly as part of the wider Capital Markets Union initiative.

ISLA will continue to engage with the regulatory community and wider stakeholders to ensure that securities financing markets continue to be the backbone of the smooth functioning of cash equity and government bond markets. The topic will also be covered extensively as part of the agenda at our upcoming 30th Annual Securities Financing & Collateral Management Conference in Lisbon between 20 and 22 June.

Andrew Dyson

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