The Assets Made Combustible When Regulators Call Them "Safe"

Op-ed in the Financial Times

June 1, 2015

Exotic assets, and the crippling losses that big and indispensable financial institutions suffered after buying too many of them, bore much of the blame for the last financial crisis. The next one might have a more paradoxical cause. Instead of being overexposed to assets of dubious provenance, many of the same institutions may be buying too many of the assets that the authorities deem safe.

Even if these assets were safe to start with, the enforced concentration is enough to make them risky.

Consider the Solvency II directive, which is intended to reduce the risk of an EU insurer becoming insolvent, and requires every such institution to hold a proportion of its assets in cash (or cash equivalents). Precisely what proportion depends on how safe regulators believe its other assets to be. Equities are deemed especially risky; insurers are required to put up cash amounting to 28 percent of the value of their holdings, to guard against the chance that the shares will fall. Short-term bonds issued by companies with high credit ratings are deemed far less risky and require cash holdings of just 3 percent. Sovereign government bonds sometimes incur no cash requirement at all. They have no choice. Determined to prevent a repetition of the crisis, regulators are forcing the holders of $100 trillion worth of assets the world over to buy debt from the most creditworthy issuers: companies and sovereigns with pristine credit histories, which comfortably generate enough cash to cover their obligations. After so many banks were sucked down by doubtful debt lurking deep within their portfolios, the impulse to usher them onto firm ground is easy to understand. But corralling a huge amount of capital into a narrow band of the market drives prices to perilous highs. Even if these assets were safe to start with, the enforced concentration is enough to make them risky.

Insurers are just the latest to face such regulations. Similar rules have been imposed on banks. Regulators require clearing houses and other intermediaries to hold more collateral than before—and it is the same small set of assets that count as collateral.

Meanwhile, central banks in Britain, the United States, Japan, and now the euro area have all conducted programs of quantitative easing, intervening in markets to buy assets using freshly minted cash. In each case, they have favored sovereign bonds. At the same time as regulated companies are being forced to buy these "safe" assets, monetary authorities have been taking away large swaths of supply.

The result is unprecedented: In the world's bond markets, almost €5 trillion of assets currently trade at prices so high that the yields on them are negative, according to data from Thomson Reuters. Among them are government bonds issued by Germany, the Netherlands, Switzerland, Austria, Sweden, and Denmark, as well as some corporate bonds, such as those issued by BP and Nestlé. Longer-dated bonds issued by European governments also attract low yields; as low as 0.077 percent, in the case of 10-year bonds issued by the German government.

Many observers argue that this is merely a temporary triumph of optimism. No one would buy bonds with yields near zero (or even lower) if they thought there was any prospect of inflation, unfavorable currency fluctuation, or anything else that might erode their value in the next five years. The exuberance will soon pass, these observers say, and yields will return to normal. It is an argument that would have merit if investors were acting voluntarily. But in many cases, their hands are being forced.

You can define particular assets as "safe," but you cannot wish away the list of economic and political contingencies that might someday cause large numbers of investors to dump them. If oil prices rise again, some borrowers will look less creditworthy. If one government defaults, investors might reevaluate others. Serious doubts could return over the integrity of the euro area.

These assets are now so overvalued that they have little chance of rising further. What they do have is a lot of downside and a lot of jittery holders. Speculators feed off such asymmetries. That may be why, in just 17 trading days between April 20 and May 13, low-yielding bonds lost $0.5 trillion of their value. There was a similarly sharp sell-off last December; then the focus was US government bonds. These are tremors before the quake. Yet systemically important institutions are being forced to linger on the fault line.

In the popular narrative, the financial crisis was caused by the willful wrongdoing of the banks. Regulators should know better. In financial markets, risky behavior is less often born of recklessness than of a false sense of safety.

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Avinash D. Persaud Former Research Staff

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