Sovereign Collateral as a Trojan Horse: Why Do We Need an LCR
75 Pages Posted: 20 Aug 2015
Date Written: August 1, 2016
Sovereign bonds are crucial for both sovereign funding and bank funding. Banks borrow in repo transactions against sovereign creditworthiness rather than their own creditworthiness. However, Basel III's current LCR does not protect banks against sovereign bond distress. Accordingly, currently compliant banks can be exposed to a neglected liquidity risk stemming from distressed sovereign debt moving through the collateral channel. This unaccounted risk can translate into a system wide liquidity shock. To gauge the potential damage caused by such a shock, we have developed a model in which sovereign distress triggers bank distress. Our model shows how deteriorating sovereign collateral can lead to an overall liquidity squeeze and non compliance with Basel III's liquidity standards. Since this risk is highly material, we conclude that LCR should address this event, and we call for an altered version - LCR. LCR is the current LCR adjusted for the liquidity impact of sovereign distress. As envisioned, LCR could have better protected banks against the non-acceptance of Greek and Irish collateral by requiring them to maintain an additional reserve against such an event.
Keywords: Sovereign Distress, Collateral Channel, Basel III, Liquidity Regulation
JEL Classification: G21, C61
Suggested Citation: Suggested Citation