Of Basel and bonds

Banks have spent a lot of time and effort poring over the details of Basel III in general and its leverage ratio in particular, but perhaps the buy-side should be paying just as much attention.

The negative impact of Basel III on banks’ capacity to provide liquidity in the bond markets can already be seen: as notional outstanding continues to rise, sell-side inventory continues to plummet, an inevitable consequence of balance sheet reduction. But some observers believe the difficulties that buy-side firms currently face in sourcing fixed-income liquidity will be as nothing compared to their likely hardships and higher costs when trying to trade corporate – and particularly government – bonds in three or four years.

The leverage ratio, which effectively sets a minimum level of capital that banks must hold as a percentage of assets, is being introduced in stages. Banks are already reporting leverage ratios to national regulators, which explains much of the capital raising and model restructuring undertaken in recent months. These filings will be made public from January 2015, with the ratio – currently 3% ­– and its supporting definitions scheduled to be set in stone at the beginning of January 2018.

The ratio has many and varied implications but bond trading seems to be a particular pain point. The unusual interest rate environment and post-crisis reforms have already combined to slash revenues on many sell-side bond trading desks, as reflected in the poor performance of FICC (fixed income, currencies and commodities) departments. But bond trading could well become an untenable business for many banks as they are forced to cost their capital even more accurately. Greater transparency will make the lack of profitability clear to senior managers and shareholders alike, with a predictable impact on the cost to clients.

Government bond trading is likely to be worse hit in terms of declining liquidity and sharply rising spreads – perhaps increasing by a factor of three – because banks make no revenue in the primary markets from issuance. At least, they can collect underwriting fees for issuing corporate bonds to offset the costs of providing services in the secondary market.

Conversations with the buy-side, not to mention a general caution about using swap execution facilities, suggest that asset managers value the service provided by brokers in the bond markets. And many on both sides realise the challenge of identifying the areas where bank intermediation is appropriate, while seeking other, perhaps highly automated, methods and tools where the sell-side can add less value.

However, it seems increasingly urgent that this work should start in earnest now, rather than under pressure of cost imperatives that dry up the market and make it all but impossible for institutional investors to get hold of the instruments they need to meet end-clients’ longer-term investment requirements. Moreover, bilateral discussions between traders and portfolio managers and their broking counterparts should perhaps be supported by awareness-raising by buy-side lobby groups.

Debt management offices understand the coming problem but are not best placed to get politicians to understand. As the voice of the investor, perhaps the buy-side might do better.