Last updated: April 22, 2013 1:14 pm
Misuse of collateral creates systemic risk
Rather than reducing risk, collateral just creates different risks
Five years after the global financial crisis, collateral arrangements remain central to financial markets. They provide security for loans, structured as repurchase agreements or as mortgages or pledges of real estate or financial assets. In derivative transactions, collateral is lodged to secure current mark-to-market exposure.
Rather than reducing risk, as theory would suggest, collateral in practice creates different risks, for a number of reasons.
First, it shifts the emphasis from the borrower or counterparty’s creditworthiness to the collateral. Parties normally ineligible to borrow or transact in the first place are able to enter into transactions. Rapid growth in debt levels, derivative contract volumes and the shadow banking system (hedge funds or structured investment vehicles) are dependent on the use and availability of collateral.
Second, the security offered as collateral is not risk free, even if it is government bonds. This introduces exposure to unexpected changes in the value of the collateral. Wrong way correlation, where the underlying risk increases at the same time as the value of the collateral decreases, reduces its utility.
Third, it assumes liquid markets for the collateral, which must be realised in case of default.
Fourth, asset liability mismatches compound the risk. For example, where the loan is for a shorter maturity than the security pledged, or where collateral must be adjusted frequently over the life of the transaction.
Fifth, collateral in practice introduces significant operational and legal risk, including enforceability of security.
Sixth, the use of collateral introduces moral hazard. While lowering collateral levels decreases protection, pressure to increase business volumes may lead to inadequate collateralisation, increasing leverage.
Finally, collateral has systemic effects, altering the functioning of financial markets, especially the quantum of credit available, liquidity risk and behaviour.
Use of collateral is an important source of endogenous – internally generated – liquidity. The practice of rehypothecation – where collateral received is repledged to support other transactions – allows expansion in leverage. But if rehypothecation is restricted, the securities committed as collateral cannot be used, causing a rapid contraction in liquidity.
Collateral use creates undesirable linkages between banks and sovereign debt, which compound crises. It encourages the creation of high quality securities that lenders are willing to lend against.
According to the Bank for International Settlements, between 1990 and 2006 triple A rated securities increased from about 20 per cent to more than 55 per cent of all securities in issue. Two-thirds of the increase was highly rated asset-backed securities, reliant on complex ratings models.
Pledging high quality assets changes priorities in bankruptcy, subordinating other lenders or counterparties to the secured creditor. Collateral also exacerbates financial distress risk, where an otherwise solvent party cannot meet unexpected margin calls. Limited disclosure of collateral provisions and potential liquidity claims makes it difficult to assess the financial position of counterparties.
Widespread collateral use exacerbates the problem of herding behaviour. In periods of stress, market participants all seek more collateral or need to sell pledged securities, increasing market instability.
Collateral use has become more entrenched, encouraged by favourable regulatory treatment. Banks rely increasingly on secured funding, including repos with central banks and covered bonds. The central counterparty, the key element of derivative market reform, is predicated on collateralisation.
Economist Hyman Minsky identified three phases of finance. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments, with the borrower relying on increasing asset values to service debt.
In the progression, asset prices become completely delinked from fundamental values until the structure collapses, as no one is willing to borrow or lend the required amounts to finance asset purchases. Inappropriate use of collateral is similar to this process.
Current concern focuses on whether collateral use constrains liquidity, restricting the supply of credit and the availability of sufficient suitable high quality securities. The real debate should be on the appropriateness of collateral use.
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
Copyright The Financial Times Limited 2013.