Persian Decision Making

18 Jun 2014 | Richard Kemmish

Herodutus said that when the Persians had a big decision to make they would first get drunk, to remove inhibitions and become more creative, then make the decision, then review it when they sobered up to see if it was still sensible.

I was reminded of this strategy when reading the final rules on asset eligibility for bank liquidity ratios. Clearly some very creative thinking had gone into them, but I’m not sure if they didn’t forget the final bit of the Persian decision process.

The rules about value haircuts (7%), own covered bonds (no), and maximum holdings (70%) are all fairly prosaic, the sort of thing that you could come up with when sober. I’m not sure that I agree with the prohibition on own covered bonds, apart from anything else this creates a bigger difference between this definition and the ECB’s definition of eligibility – which does allow own covered bonds. I would argue that there is a strong case to align the definitions completely as stress scenario liquidity is ultimately central bank based anyway.  But at least these rules are conventional and defensible.

The real second bottle idea though is that banks should sell a portion of their covered bond holdings every year to prove that they are liquid in practice. Original, but flawed for three main reasons.

Firstly, the same outcome can be achieved without actually having to sell the bonds (hopefully the regulators don’t want to proscribe behaviour for the sake of it). The reserves that many trading books have to hold is based on an estimate from their product controllers of the cost of liquidating their entire bond portfolio (relative to the current carrying cost). The product controllers invariably base the amount of the reserve on their own analysis of the liquidity and bid/ask of the bonds and, as they are product controllers, therefore notoriously cynical, these are likely to be at best conservative assumptions.

Presumably the 7% value haircut is trying to achieve more or less the same thing as the product controllers but in a far less sophisticated way, so why both haircut and ‘test sales’? 

A second problem is how easy it would be to manipulate. Obviously investment banks have never acted in anything other than an ethical way, but if they ever did it would be the easiest thing in the world for them to set up switches of bonds between bank treasuries to achieve the semblance of liquidity without the costs and market risks.

But the biggest problem is surely that selling bonds into a normal market tells you precisely nothing about your ability to sell them when you need them. I’ve been told, in all earnestness that car loan securitisations are much more liquid than pfandbrief, based on a long term analysis of trading volumes. Pity that they don’t look so good based on a short term analysis if that short term happens to be a liquidity stress scenario. 

Thanks for the creativity. But maybe its time to take a more sober look at the proposed rules.

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