Recent turmoil in the banking sector, with the collapse of several banks in the US and Europe, has shone a spotlight on two key areas of risk for treasurers – liquidity and credit risk. Why?
Investments in short-term credit are vital for managing cash, allowing treasurers to balance security of capital, liquidity, diversification and a competitive yield. However, this was uniquely tested during the latest crisis in March 2023. Although it did not result in significant market dysfunction, as has been the case in the past, the market did not function entirely smoothly either.
The short-term debt markets can largely be split into government and corporate issuers. Investments in government bonds, either directly or indirectly via money market funds, are often used to manage liquidity, especially in the US. However, as a result of reforms that followed the global financial crisis (GFC), liquidity in the government bond market has been reduced, which is of particular importance for investors in treasury and government funds. Alongside this, for the treasurers and funds that invest in corporate issuers, the importance of managing credit and counterparty risk has been highlighted by the recent US banking crisis, which also saw the collapse of Credit Suisse, a global systemically important bank.
This has again highlighted the need for treasurers to understand the liquidity and credit risks that can exist to better identify how to mitigate them, particularly in times of uncertainty and market volatility.
1. Increased liquidity risk in US treasuries
US treasury bonds, as the largest and one of the most liquid risk-free asset classes, are a key instrument used by money market funds (MMFs). As a result, US treasury market liquidity is of paramount importance and provides useful lessons for other, smaller markets such as sterling and euro MMFs.
Ever since 2020, there has been recognition by regulators and fund managers that treasury markets have been under increasing stress, with tensions exacerbated by the move from extensive quantitative easing to a sharp hike in interest rates across the western world.
Understanding these changes is key to understanding periods of volatility. Key among them are:
- Evolving regulations forcing banks to hold capital against treasuries, as part of the Supplementary Leverage Ratio (SLR). This resulted in primary dealers less willing to hold RWA-expensive treasuries with their proportion of traded treasuries falling from 14% to 2%. Although hedge funds, high frequency traders, and other institutional investors have increased their holdings, the pool of stable investors has shrunk significantly, and they are not able to fulfil that role.
- The US government’s deficit has grown and has continued to outpace the already constrained primary dealers’ ability to absorb extra treasuries. The withdrawal of quantitative easing in 2022 has exacerbated this issue. Together, this greater supply and the more limited ability to accommodate it has led to a systemically more fragmented and fragile market.
US regulators and the Fed have moved to mitigate these fragilities by:
- suspending the SLR rule for treasuries (2020-21), since when holding them has become expensive again
- initiating a large bond purchase scheme (2020-22)
- changing the Federal Reserve’s discount window to price treasuries held as collateral at par, rather than according to market price (2023)
- use of the standing repo facility, instituted in 2021 (2023).
Further changes to the treasury market are expected over the next few years, following the approach of the US’s Inter-Agency Working Group on Treasury Market Surveillance (IAWG). They have two main proposals:
- to obtain better insights of the treasury market with improved data
- a central clearing house for treasuries, replacing the primary dealers.
Despite uncertainty during the early days of the 2023 US banking crisis, the markets continued to function due the limited scale of the bank failures, the lack of contagion and the restrained impact on the broader economy.
However, the market liquidity’s structural fragility remains in focus. Should more difficult economic conditions begin to emerge towards the end of 2023, it is not hard to imagine another real-life test of market liquidity taking place.
Liquidity risk: actions for treasurers
Treasurers should review and challenge their fund managers on how they manage liquidity risk. A key challenge is the approach taken to minimum standards – especially in areas such as:
- overnight liquidity
- client concentration.
Focus on how investment managers implement regulatory minimums for liquidity and how that impacts the risk-yield profile of any fund.
Table: S&P Long-Term Credit Rating
Source: Bloomberg, HSBC Asset Management
2. Credit risk
Credit quality of corporate issuers is of particular importance in a higher interest rate environment and economic backdrop that is uncertain, with sticky inflation and low growth. However, as of the end of March 2023, the majority of global systemically important banks have had their credit ratings affirmed (see table above), and the global banking industry remains a high single A-rated sector .
Although the larger banks are relatively well positioned today, areas of credit risk remain. These include:
- a risk of commercial real estate defaults
- a potential rise in general levels of non-performing loans
- rising interest rates affecting the ability of sovereign issuers to service their growing debt burden leading to country downgrades or credit watch, which may in turn affect the ratings of banks domiciled in their jurisdiction.
Credit risk: actions for treasurers
Treasurers need to understand what fund managers are investing in, especially following recent bank collapses.
In addition, treasurers should:
- understand how the fund manager manages credit migration. Do they proactively approach credit by managing maturities for specific issuers? Do they have internal teams monitoring credit risk or do they rely on the major credit rating agencies
- monitor if the fund managers have an appropriate focus on those banks (and countries) where downgrades will either decrease liquidity or result in a rating that is lower than permitted for a rated MMF
- monitor credit migration from a sovereign to a resident bank and also across banks in the same geography/sector.
Pay attention
While a broad-based downgrading of the banking sector is not expected, the possibility remains for a more selective re-rating of individual banks and country banking sectors. Credit assessment processes should flag issues in advance and, even if the outcomes are worse than expectations, an investment focus, as detailed above, will allow treasurers to effectively manage them through any period of ratings changes.
Above all, treasurers must continue to pay attention to liquidity and credit risk – especially below the surface. One storm is over but there may be others on the horizon.