LONDON (Reuters) – Banks are in danger of a “vicious cycle” from the need to pledge more of their best quality assets as protection to central banks and other creditors, which could hinder the banking system’s ability to absorb shocks.
The trend, known as “asset encumbrance”, has taken hold over several years and stems from a crisis of confidence that forces banks to pledge an increasing proportion of their assets as collateral to central banks or for new debt issues.
“Asset encumbrance … weakens the ability of the system to absorb shocks,” the Bank for International Settlements (BIS) said in its annual report on Sunday.
The more assets are pledged, the more vulnerable a bank is to margin calls, and to any event that could force many banks to replenish their collateral at the same time, the BIS said.
European banks in particular have needed to offer more protection to creditors unnerved by risks including their exposure to troubled sovereign debtors. This in turn encumbers assets, making them no longer available to holders of a bank’s unsecured debt in the event the bank fails.
“Since this raises the riskiness of unsecured debt, collateralised debt becomes even more attractive to investors, potentially setting in motion a vicious cycle,” the BIS said in its annual report.
“And when private sources of funding withdraw from markets, banks use collateral to obtain official support, thus further encumbering their balance sheets.”
The BIS said a fifth of European banks’ assets were encumbered in 2011, bloated by increased reliance on secured loans from central banks. In Greece, encumbered assets jumped to one-third of total assets last year, and there have been big rises for Irish, Italian and Portuguese banks.
BIS, the global forum for central banks based in Basel, Switzerland, said restoring the health of the banking sector “requires immediate policy actions” to ensure banks recognise losses and recapitalise, suggesting this would restore investor confidence and reopen access to funding markets.
Banks have markedly strengthened their capital since the financial crisis, and between 2008 and 2011 large European, U.S. and Japanese banks have raised their common equity-to-total assets ratios by 20 percent, 33 percent and 15 percent, respectively, the BIS said.
But banks need to offer more clarity on the models they use to measure asset risk and set equity capital buffers.
A large disparity in the capital buffers at banks using internal ratings models “could be a sign of systemic vulnerability if some models deliver overly optimistic conclusions in order to justify low capital-to-assets ratios,” the BIS report said.
It said assessing the models and harmonising their application have become priorities for the Basel Committee on Banking Supervision, which sets global standards.
Regulators in emerging markets cannot be complacent, BIS warned. “Rigorous, through-the-cycle assessments should shape regulatory measures in rapidly growing economies where buoyant markets exaggerate the financial strength of banks and encourage risk-taking,” it said.
(Reporting by Steve Slater; Editing by Ruth Pitchford)