Sovereign Collateral as a Trojan Horse: Why Do We Need an LCR

75 Pages Posted: 20 Aug 2015

See all articles by Christian Buschmann

Christian Buschmann

Frankfurt School of Finance & Management gemeinnützige GmbH

Christian Schmaltz

Aarhus University; True North Institute

Date Written: August 1, 2016

Abstract

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

Buschmann, Christian and Schmaltz, Christian, Sovereign Collateral as a Trojan Horse: Why Do We Need an LCR (August 1, 2016). 28th Australasian Finance and Banking Conference, Available at SSRN: https://ssrn.com/abstract=2647661 or http://dx.doi.org/10.2139/ssrn.2647661

Christian Buschmann (Contact Author)

Frankfurt School of Finance & Management gemeinnützige GmbH ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Christian Schmaltz

Aarhus University ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

True North Institute ( email )

145-157 St. John Street
London, EC1V 4PY
United Kingdom
+49-17621761996 (Phone)

HOME PAGE: http://www.tninstitute.eu

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