Bank Collateral Disclosure Will Improve Risk Appraisal, BIS Says

Banks should disclose the assets they pledge as collateral for loans so that investors have a better gauge of risk, according to a committee of the Bank for International Settlements.

Lenders could be asked to carry out stress tests to evaluate levels of assets they have tied up, known as encumbrance, under adverse conditions, the committee said in a report. Banks that commit large amounts of collateral could be asked to contribute more to deposit guarantee arrangements, according to the report.

“Transparency about the extent to which bank assets are encumbered or are available for encumbrance will allow unsecured creditors to better assess the risks they face,” according to the report.

After the financial crisis of 2008, banks’ funding models changed, with collateralized borrowing gaining a bigger role. Using assets such as government bonds as security reduces what’s available to be sold to pay unsecured creditors should there be a default and increases the cost of winding up the institution.

The change to collateralized funding, combined with regulations forcing lenders to hold more high-quality, liquid assets and stricter margin requirements for derivative trades, raised concerns that there may be a shortage of such securities. The report cites an estimate of about $4 trillion of additional demand for high-quality assets.

Aerdt Houben of the Dutch Central Bank led the working group that produced the report. The Basel, Switzerland-based BIS was formed in 1930 to monitor financial markets and regulate banks.

Banks and brokers face a clampdown on using assets they hold for clients as collateral for their own trades as part of European Union moves to bolster market stability and rein in shadow banking.

The European Commission is weighing whether firms should have to obtain formal consent from their clients before being allowed to reuse assets to back other trades, according to a document obtained by Bloomberg News. The consent would be enshrined in a “contractual agreement” between the parties.

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