Poor things: It looks like the banks are going to be forced to eat a truck load of government debt.

10/06/2009 1:28 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

It's a neat (partial) solution.

Governments around the developed world have been issuing billions--make that trillions--in new debt in order to pay for the bail out of the global financial system.

The worry, of course, is that at some point the world would see a buyers' strike and the United States and the United Kingdom, two of the biggest issuers of new debt and two of the most fiscally challenged of developed economies, would be stuck with the need to raise money in a market that didn't want any more of their paper.

Well, you can worry a little bit less. It's the world's banks to the rescue. So what if they're riding to the rescue only because financial regulators are holding a gun to their heads?

This "solution" started to emerge on Monday October 5 with news from the Financial Services Authority, the regulator in charge of the financial markets in the United Kingdom, that new rules would require banks to increase their holdings of high-quality, easy-to-sell assts by roughly one-third in the first year after the rules go into effect. That's about $175 billion.

The Financial Services Authority hasn't announced when these rules will go into effect.

As policy this makes sense. One of the reasons that the recent financial crisis was so severe is that banks had too much of their capital locked up in assets that they couldn't sell when they needed to. On paper they were still amply funded but in actuality they couldn't put their hands on the money. That's because the markets for these assets, which everybody had known were illiquid, turned out to be even more illiquid than expected.

These markets, in fact, stopped functioning. Can't get much more illiquid than that.

Banks had made the effects of this illiquidity even worse by using short-term funds raised in the commercial paper market as the source for so much of the money they lent out. When that market refused to roll over those 90-day borrowings, banks found that they needed to sell other illiquid assets but couldn't.

So one of the post-crisis reforms will be to require banks to keep more of their balance sheets in stuff they are sure they can sell in another crisis and furthermore in stuff that's easy to price. In the last crisis banks held only about 5% of their balance sheet in liquid assets. The new rules, estimates Credit Suisse, would push that to 15%.

Well, guess what fits that description according to the rules from the Financial Services Authority? High-quality bonds issued by the government of the United Kingdom. It looks as if the bonds of other institutions that have helped fund the bailout such as the European Investment Bank, an arm of the European Union, would meet the test too.

Banks do have an option under the rules. They can avoid having to buy so many high-quality government bonds by cutting back on their reliance on short-term commercial paper for funds.

The banks aren't going to be forced to eat enough paper to end the danger of a global buyers' strike down the road. Ev en after the United States adopts similar rules now under discussion. Still it will help.

There is no free lunch, though. By forcing banks to hold more of their assets in safe, more liquid assets, regulators will wind up reducing bank profitability. Reducing their reliance on the short-tem capital markets, which in normal times charge very low rates for money, will also reduce bank profits.

The one way out of this profitability trap that I can see is for banks to raise more of their funds from despositors. That would lower their reliance on the short-term capital markets and reduce the amount that they have to hold in less risky and lower yielding liquid assets.

Like many other trends in the banking sector, this regulatory tide seems to be running in favor of those banks that are the most efficient, large-scale gatherers of deposits.
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