Potential Regulation and the Effect on Short-term Fixed Income Markets

As a result of the recent financial crises, financial regulators are seeking to design additional regulation to prevent excessive risk taking and illiquidity of the global financial system. Included in these efforts have been the Basel III proposals focusing on large global banking institutions. Separately, the President’s Working Group (PWG) has released their long awaited report on increasing the regulation of US 2a-7 money market funds (MMFs) in recognition of their role they play in the short-term funding markets.

Banking Regulation – Basel III

The latest credit crisis has highlighted the interconnectivity between central governments and their financial institutions and while the bond market’s apprehension of the European sovereign debt crisis has diminished, it certainly is not over. In response, the Basel Committee on Banking Supervision has been working on proposals to strengthen the banking sector’s ability to withstand the severe financial and economic stress caused by the credit crises. The Basel Committee is composed of banking regulators from a number of industrialised countries with the core membership from Europe, the US and Japan. The first set of Basel Committee rules were released in 1988 as Basel I with the first major revision proposed in June 2004 as Basel II. Basel III, the current revision to the original set of rules, seeks to increase the level and quality of bank capital, address leverage and introduces a global minimum liquidity standard. These proposals received a broad endorsement but were not ratified as previously expected during the G20 Leaders Summit in Seoul, Korea on 11-12 November 2010.

Although the proposals are not yet finalised, they represent a significant enhancement to the Basel II rules as proposed and will strengthen the credit profile of the banking institutions covered by the rules. The higher capital ratios would be phased-in beginning in 2013 with full implementation due by 1 January 2019. Broadly speaking, banks’ Tier 1 common ratio will increase from 2% to 7% over this period.1 The proposal also introduces a liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR) to promote resiliency of these banks’ funding and liquidity profiles during a prolonged credit crisis that would be phased-in beginning 2015 and 2018, respectively. The LCR requires these firms to hold high-quality liquid assets equal to or greater than 100% of the net cash outflows over a 30-day time frame. The NSFR requires sufficient stable medium-term and long-term funding against the assets and activities over a one year horizon.2 Interestingly, the Basel II rules have not been fully implemented prior to the new proposals and some investors are pressuring banks’ to implement the proposals before the required timeframe.3

Potential Impact of Basel III

Clearly, requiring banks to hold additional capital to buffer against losses are a credit positive for bond investors; however, the LCR may have a significant unintended impact on the fixed income markets and credit availability. Banks currently have sizeable liquidity portfolios of high-quality short-maturity securities like US treasury bills and agency discount notes (ADRs). However, the proposals will require all potential cash outflows, including an assumption of an immediate 100% draw on all outstanding credit lines, for a 30-day period to be supported by liquid securities.

The market impacts of these proposals could be a substantial decrease in many short maturity debt obligations such as commercial paper (CP), asset-backed commercial paper (ABCP) and municipal variable rated demand obligations (VRDO) due to the added cost of providing bank credit lines and meeting the LCR. ABCP and VRDOs, which structurally require a bank liquidity facility, may feel the full impact as the increased cost is passed on to their end-clients. This potential decrease in outstandings occurs while simultaneously increasing the demand for short maturity government securities to comply with the LCR could result in a very flat money market curve coupled with a not insignificant reduction in credit availability.2,4 In addition, the heightened cost of providing credit provides an economic incentive for banks to reduce credit availability which may cause corporations to respond by increasing their cash holdings at the expense of capital investment and hiring at a very inopportune economic time.

Updates on the State of the ABCP and VRDO Markets

After declining approximately 66% from the record high in June 2007, the US ABCP market has stabilised around US$400bn since the end of the first quarter of 2010.5 This currently represents around 37% of the entire US CP market, substantially lower than the 57% of the US CP market in 2007. The composition of the programme types has largely shifted back to traditional bank-sponsored multiseller conduits, representing approximately 70% of market outstandings, with the underlying asset classes closely matching investor’s preference for more predictable performance such as trade receivables and consumer loans.6 Programmes that relied on market-based liquidity with complex structures and conduits with concentrated risk to a single-seller or asset class have been removed from the market.

Variable rate demand obligations (VRDOs) are long-term, tax-exempt bonds issued by municipalities whose interest rates typically reset on a daily, weekly or monthly basis with an estimate US$390bn market.7 VRDOs are issued with long-dated maturities of 20 to 30 years with a put feature that allows an investor to put the bond back to an investment dealer at par with any accrued interest. This put feature is supported by a letter of credit (LC) and or a standby bond purchase agreement (SBPA) typically provided by large financial institutions. These credit and liquidity enhancements provide compliance to SEC Rule 2a-7 and provide for high credit ratings from the respective credit rating agencies.

MMF Regulation – PWG

The PWG was formed as a result of the Treasury Department’s call for stronger regulation of MMFs in conjunction with the SEC Rule 2a-7 amendments. The PWG is comprised of the Secretary of the Treasury, the Chairman of the Federal Reserve Board (FRB), the Chairman of the Securities and Exchange Commission (SEC) and the Chairman of the Commodity Futures Trading Commission (CFTC), undertook a study of possible further reforms that individually or in combination, may mitigate the funding risks posed by a money market run and suggested eight ideas for additional regulatory changes. The PWG does not endorse any of these potential policies but rather identifies them as possible options and has directed the SEC to issue a request for comment from the various stakeholders with a 60-day comment period.

The eight options proposed by the PWG report are:

  1. Floating net asset value (NAV).
  2. Private emergency liquidity facility.
  3. Mandatory redemptions in kind.
  4. Insurance for MMFs.
  5. A two-tier system of MMFs with enhanced protection for stable NAV funds.
  6. A two-tier system of MMFs with stable NAV funds reserved for retail investors.
  7. Regulating stable NAV MMFs as special purpose banks.
  8. Enhanced constraints on unregulated MMF substitutes

These proposals will be examined by the newly established Financial Stability Oversight Council which could be implemented by the SEC under current statutory authorities to broader changes that would require new legislation and coordination by multiple government agencies. Following the comment period, a series of meetings will be held in Washington, D.C. with various stakeholders, interested persons, experts and regulators.

Change is Coming

The Basel III proposals may pull issuers out of the short-term market in favor of longer-term funding while the PWG proposed options will present significant changes to the money fund industry. While we can’t be certain of the final form of the regulation, we can be certain that change is coming.

1 Basel III: A significant positive for bondholders, Barclays Capital, 29 September 2010.
2 Short-Term Fixed Income Market Update, J.P. Morgan, 13 October 2010.
3 Ackermann Says Investors Want Basel Rules Implemented by 2013, Bloomberg L.P., 18 October 2010.
4 US Fixed Income Weekly, RBC Capital Markets, 9 September 2010.
5 Federal Reserve as of 10 November 2010.
6 Quarterly Short-Term Credit Market Update, 3rd Quarter 2010, Morgan Stanley.
7 Basel may be Threat to Money Funds, The Bond Buyer, 23 September 2010.


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