On the 21st of June, Moody's announced the downgrading of 15 global banks and financial institutions, including British firms, Royal Bank of Scotland, Barclays and HSBC.
Following the downgrading, the 15 banks affected must now find increasingly innovative ways to allow them to continue trading at the same volumes of OTC derivatives to encourage profitability. Those that have been downgraded will face a struggle to post collateral in their transactions with other banks.
This is problematic as capital and collateral are the financial firebreaks that will prevent future systemic crises, or at least buy time for the central bank fire brigade to dowse those flames with liquidity.
In practice, clearing houses are setting extremely conservative collateral eligibility parameters, emphasizing cash and a narrow universe of government and agency bonds. In parallel, OTC reform is driving demand for the same narrow universe of highly liquid assets -- assets that are already intensively used in the secured lending markets for funding and liquidity management purposes.
This is resulting in the so-called 'collateral crunch'; the intensity of demand for the highest quality collateral-eligible securities is starkly illustrated by their historically low yields. Estimates for the incremental value of liquid assets required extend to the trillions of dollars, and the efficient sourcing and deployment of these assets therefore becomes critical if anything like current levels of activity and returns are to be sustained. Facing this pressure, institutions that systematically source and deploy collateral at minimum cost will reap the benefit of lower funding costs and, potentially, generate returns from active collateral trading.
In an environment where banks must focus on profitability to bolster core equity, there is a clear incentive to address the collateral optimization challenge. However with the downgrading now having taken place this pressure will be even more intensified on the banks.