Heading'em Off at the Collateral Pass

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Collateral is one of the foundations of banking. An old aphorism says that a banker will only lend you money if you can prove that you don't need it. Collateral is that proof. You can pledge your house against a cash loan, and if you fail to repay, the bank takes the house.

The financial strength of a bank can be measured by the volume and quality of its collateral. Good collateral includes real property, government bonds issued by countries with stable finances, and high-rated corporate bonds. Bad collateral includes illiquid assets, dodgy equities, government bonds from countries at risk of default, poorly executed collateralized debt obligations, and other promises backed by specious claims.

The financial crisis reduced the supply of good collateral. Government bonds were downgraded, the market for collateralized debt obligations was upended, corporate debt became riskier to hold, and both homeowners and companies experienced a prolonged period of financial distress. Consequently, the global financial crisis impaired the entire banking industry -- not just those institutions directly involved in causing the crisis.

Regulators responded to the financial crisis by insisting that banks hold greater volumes of higher-quality collateral to better prepare for the next crisis. One example of such regulation is the recent proposal that would require global banks operating in the US to show that they have local capital and local liquidity, i.e., good collateral available domestically in case of a crisis. Another example is the Dodd-Frank requirement that over-the-counter derivatives be cleared through Central Counterparty (CCP) clearinghouses. The functioning of CCPs goes beyond the scope of this blog post, but suffice it to say that CCPs require collateral to function.

From here, it's basic economics: Reduced supply plus increased demand leads to higher prices, which is what's happening in the market for collateral. In the good old days, collateral was everywhere, even manufactured out of mortgage pools, with more than enough to go around. Now, regulators are mandating that banks hold good collateral even as that good collateral is harder to find or synthesize.

By way of comparison, consider the recent shortages in once-plentiful rare earth metals, now in short supply given the explosion in global demand for mobile devices. In response, the computing industry has attempted to diversify sources of supply, increase recycling efforts, and minimize waste. In the financial services industry, similar efforts are underway to conserve collateral.

A presentation at the Sibos banking industry conference in Osaka, Japan, described one approach to pooling, optimizing, and allocating collateral -- a "collateral highway" that will allow global banks to quickly move assets from one part of the balance sheet to another. "Clients can manage and utilize a virtual pool of assets, and then mobilize those assets to the relevant central counterparties, or to the central bank or commercial banks," said Jo Van de Velde, managing director and head of product management for Euroclear.

Similarly, Clearstream enters into strategic partnerships with clearinghouses, stock exchanges, and custodian banks to provide the technology for collateral management. "We're not demanding the opening of an account and an initial transfer of collateral into a Clearstream account structure," explained Stefan Lepp, CEO of Clearstream Banking AG, speaking at a Sibos panel. Therefore, in the case of a default, the underlying collateral is still visible to local regulators and accessible by domestic players.

Both of these approaches are akin to scavenging parts from old mobile phones to find the rare earth metals needed to make new mobile phones. Through these and similar efforts, it won't be long before the financial industry will have deployed solutions that ensure that every dollar of good collateral is put to the most effective use. That's the easy part.

What's harder is delineating a clear boundary between good collateral and bad collateral. Those edge cases will become a challenging area for regulators and a source of potential profit and risk for bankers. The best-performing banks in this environment will be those that can originate, manufacture, or synthesize good collateral based on sound underlying assets. With that, we're also likely to see high-flying banks taking liberties with the definition of good collateral. When that happens, the availability of collateral highways and other rapid transfer mechanisms will accelerate the speed at which those questionable assets will propagate throughout the banking system.

To avoid another crisis in this area, government regulations combined with industry-led, self-regulatory mechanisms will have to establish, enforce, and maintain quality control mechanisms to ensure that collateral is as good as it's purported to be. Otherwise, we're back where we started five years ago, except that everything will happen faster than it did last time.

In the comments, share your favorite stories about collateral along with other asset-backed comments.