Banks Ready to Use Low-Quality Collateral If It’s Cheap

One in three financial institutions would accept “low-quality, complex and opaque” collateral to back trades provided that it’s “cheap,” according to a survey from the operator of Switzerland’s exchange and clearinghouse.

More than half -- 57 percent -- of the 60 industry participants surveyed on behalf of SIX Group said that the cost of collateral was more important than its quality. About 48 percent of the respondents answered that securitizing and repackaging existing securities to create pools of collateral would increase risk, possible leading to another financial crisis. Some 43 percent said they wanted “simple, high quality, liquid and easy to value” collateral, the survey found.

“It is a frightening prospect that in today’s market, over a third of financial institutions are willing to accept collateral simply because it is cheap,” said Robert Almanas, managing director for international services at SIX Securities Services. “When our competition begins to compete on the quality of collateral they are prepared to take, the ‘race to the bottom’ becomes a very real outcome.”

Institutions may need as much as $6.7 trillion in additional collateral to satisfy new bank capital rules and swaps-clearing mandates, securities-industry consultancy Finadium LLC said in December. The lack of cost-effective assets to back swaps trades has prompted some market users to exchange lower-rated securities for cash or highly rated securities, the Concord, Massachusetts-based firm specializing in securities lending and collateral management said. It described the practice as collateral transformation.

The U.S. Dodd-Frank Act, the Basel III accords and the European Market Infrastructure Regulation initiative will drive more swap trades through clearinghouses. Financial institutions will have to seek different sources of collateral because clearinghouses require upfront collateral. CME Clearing Europe now accepts physical gold as collateral, extending the list of assets it’s prepared to receive.

Vanson Bourne conducted the survey on SIX Group’s behalf in December, interviewing industry participants in the U.K., France and Germany.

To contact the reporter on this story: Nandini Sukumar in London at nsukumar@bloomberg.net

To contact the editor responsible for this story: Andrew Rummer at arummer@bloomberg.net

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