by Don Alexander, MBA
Associate, RSD Solutions Inc.
The financial crisis has raised concerns about sovereign debt sustainability has reinforced the notion that no asset can be viewed as truly safe. Recent rating downgrades of sovereigns previously considered to be virtually riskless have reaffirmed that even highly rated assets are subject to risks. The notion of riskless assets—implicit in credit rating agencies’ highest ratings has created a false sense of security, especially as the demand for these assets increase while supply shrinks.
The International Monetary Fund Global Financial Stability Report (GFSR) Safe Assets: Financial System Cornerstone? (April 2012). Report looks at the role of safe assets; the effects of different regulatory, policy, and market distortions; and potential future pressure points.
Safe assets have varied functions in financial markets, including as a store of value, collateral in repurchase and derivatives markets, key instruments in fulfilling prudential requirements, and pricing benchmarks. Without distortions, safety is priced efficiently, reflecting demand-supply dynamics.
The demand and supply imbalances in global markets for top rated assets are not new. Prior to the crisis, current account imbalances encouraged safe asset purchases by reserve managers and sovereign wealth funds. Now, demand is being driven by periods of uncertainty, the lack of clarity about regulatory reforms, increased collateral needs for over-the-counter (OTC) derivatives transactions and the use of such assets in central bank operations.
Conversely, on the supply side, GFSR report estimates the number of safe sovereigns may decline by $9 trillion by 2016, or 16 percent. Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs. The shrinking supply of safe assets, now limited to high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. Safe asset scarcity could lead to more short-term volatility jumps, herding behavior, and runs on sovereign debt.
In the case of banks, the preferential treatment of sovereign debt in banking regulations can increase the use leverage. The upward bias to capitalization ratios can lead to overestimation of the capital buffer available during periods of market stress. Under current regulations, banks’ holdings of debt issued by their own governments—and in the case of the European Union, of the debt of any sovereign in the Union—are commonly assigned zero risk weights.
To mitigate the risks to financial stability, policymakers need to strike a balance between flexibility, the soundness of financial institutions and the costs associated with a too-rapid acquisition of safe assets. Specifically, the careful design of some prudential rules could help increase the differentiation in the safety characteristics of eligible safe assets and limit potential runs on individual types of assets. On the supply side, desirable policies include improving fiscal fundamentals and encouraging the private production of safe assets through improved securitization practices. These efforts can remove impediments that may inhibit safe asset markets from moving to a new price for “safety.”
For more on this follow the link: http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf
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