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Liquidity Swaps

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Published: 4th August 2011 by William Webster

Put a bank that has difficulty in raising liquidity in a room with an insurance company that's looking for yield and what do you get?

Answer: A liquidity swap

That's where the bank takes some illiquid assets and uses them as collateral to borrow some gilts from the insurance company.

It’s a nice little earner for the insurance company who receives a fee whilst the bank can switch the gilts through the repo market to get cash.

Latent liquidity in the insurance business is transferred to banks whilst pension fund assets get uplifted yield.

It’s a win-win situation or is it?

It's the topic of a Guidance Consultation from the FSA issued in July 2011. This considers how to identify such a transaction whether it is by way of stock loan, repo or total return swap. It then identifies the risks involved and suggests how these should be treated from a capital perspective.

These transactions are taking place and reading between the lines the FSA appears to see them as being useful provided risk management is robust.

Indeed a significant amount of the consultation looks at the risks incurred for both parties and makes it clear that firms with inadequate risk controls will be subject to additional Basel 2 capital add-ons.

This is all good regulatory thinking and is par for the course in the new intrusive regime but you have to ask yourself whether one party from the debate is missing. That's you. Not as a market participant but both as a taxpayer and saver.

In the event of systematic failure in the banking system what affect would liquidity swaps have? That's impossible to predict but the FSA does provide some clues on this by way of an Annex (Market Failure Analysis - The Rational of the Guidance).

If a bank failed, encumbrance of its assets by way of liquidity swaps potentially increases losses for both depositors and the FSCS.

Furthermore it leaves the insurer with illiquid assets (which will need to be held to maturity and in the process will incur greater credit losses than the gilts the insurer originally invested in).

Had liquidity swaps been widespread in 2007-8 then the FSCS would have incurred larger payouts and some insurance companies (who incidentally pay out pension annuities) would now be sitting on structured securities and illiquid assets instead of Gilts. There's no free lunch in these markets.

Given recent events the FSA should ask a fundamental question.

Shouldn't some types of business that provide the public with safe investments and annuities be prohibited from entering liquidity swaps?

Banks and insurers may think its ok. But this isn’t a market just between professionals. It's where the man in the street can get badly hurt through no fault of his own.

Sharpen up FSA.

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