THE SYSTEMIC RISKS OF RESTRICTING COLLATERAL FLUIDITY: IMPLICATIONS OF ASSET ENCUMBRANCE

What is Asset Encumbrance?

From a legal standpoint, asset encumbrance refers to a claim on property by another party, such as a lender. Financially, it involves pledging assets as collateral for a loan, creating a “Security Interest”. If the borrower defaults, the lender can seize and liquidate the collateral to recover funds. This gives secured creditors priority over unsecured ones in bankruptcy, often referred to as "Structural Subordination." Essentially, using collateral to secure loans encumbers the pledged assets.

“Security Interest” - is a legal right granted by a borrower to a lender over the borrower's property, which serves as collateral for a loan. It gives the lender the ability to claim or seize the pledged asset if the borrower fails to repay the loan as agreed.

Why is Asset Encumbrance Important?

Asset encumbrance is a key concern for regulators due to its impact on:

• Unsecured Creditors: It reduces the recovery rates for depositors and unsecured creditors in the event of a bank’s default.
• Deposit Insurance and Bail-in Mechanisms: Encumbered assets complicate deposit guarantee schemes and bail-in processes.
• Liquidity Risk: Secured lenders face increased risks as fewer unencumbered assets remain for liquidity buffers.

Regulators emphasize maintaining sufficient unencumbered assets to enhance banks’ resilience and provide liquidity during stressed conditions by holding a liquidity buffer against “Roll-over risk”.

"Rollover risk in stressed conditions" - refers to the heightened risk that a bank might face when trying to refinance maturing debt during a period of economic turmoil, where market liquidity is low, credit availability is tight, and lenders are less willing to provide new loans, potentially leading to difficulty in rolling over existing debt at favourable terms or even defaulting on payments.

This article focuses solely on "Collateral Management" and is not intended to be interpreted in the context of liquidity ratios or related perspectives.

Does Repo Encumber Assets?

Not all transactions encumber assets the same way. For example, collateral pledged for derivatives fully encumbers those assets, leaving unsecured creditors without a claim during bankruptcy.

Repos, however, differ. In Europe, under the Global Master Repurchase Agreement (GMRA), repos involve the transfer of legal ownership of the assets from the repoer to the reverser, making it an outright sale with an agreement to repurchase.

In the event of bankruptcy of the repoer, unsecured creditors do not have a claim on the repoed assets, since legal title has passed to the reverser. Instead they will have a claim on the cash received by the repoer, or whatever assets this cash has been used to purchase. In this respect, repo does not encumber assets.

To explain this further:In the case of repos, at least in Europe (which are usually transacted under the Global Master Repurchase Agreement), legal title to the repoed assets is passed from the repoer to the reverser. It is essentially an outright asset sale with an agreement to repurchase the asset at a future date. In the event of bankruptcy of the repoer, unsecured creditors do not have a claim on the repoed assets, since legal title has passed to the reverser. Instead they will have a claim on the cash received by the repoer, or whatever assets this cash has been used to purchase. In this respect, repo does not encumber assets.

Repos cause minimal asset encumbrance, typically linked to:

• Haircuts: The over-collateralized portion of a repo transaction may be considered encumbered.
• Contingent Risk: Encumbrance depends on potential losses from selling the collateral at a price lower than the repo value, including any haircuts and variation margining.

Overall, any encumbrance from repos is marginal and partly contingent, influenced by the quality of the collateral and the haircut terms.

“The over-collateralized portion of a repo transaction” - In a repo transaction, the "Over-collateralized portion" refers to the amount of collateral value that exceeds the amount of cash being borrowed, essentially providing extra security to the lender by having collateral worth more than the loan itself; this excess value is considered the "Haircut" in the transaction, acting as a buffer against potential losses if the collateral value drops during the repo period.

There is often confusion caused by using terms like 'repo,' 're-hypothecation,' 'pledge,' and 're-use' interchangeably. This lack of clarity can lead to misunderstandings, especially when discussing asset encumbrance, as these terms have distinct meanings and implications in financial transactions.

Re-hypothecation:

Re-hypothecation refers to a pledgee’s right to reuse or sell a pledgor’s assets, such as through a sale or repo. When this right is exercised, the pledgor’s ownership is replaced by a contractual claim to receive equivalent assets later. Hedge funds commonly grant re-hypothecation rights to prime brokers for assets in segregated custody accounts, secured by a pledge.

Why do we need to get asset encumbrance right?

Measuring asset encumbrance is critically important, particularly in assessing risks to unsecured lenders. However, not all transactions encumber assets in the same way, or to the same degree. In the case of repos, for instance, any encumbrance is at best marginal. These nuances are often overlooked, and there is a tendency to view all Secured Funding Transactions (SFTs) in the same way.

The EBA, for example, defines asset encumbrance as:

‘…an asset is considered encumbered if it has been pledged or if it is subject to any form of arrangement to secure, collateralise or credit enhance any transaction from which it cannot be freely withdrawn.’        

Conclusion:

At a time when the market is facing potential collateral supply-demand imbalances, and where there is an increasing need for improved collateral fluidity, it is essential that regulators do not misidentify asset encumbrance or restrict the usability of unencumbered assets.

Question to my Followers:

How can banks accurately identify unencumbered assets as a proportion of their total holdings, especially when addressing potential collateral supply-demand imbalances and the growing need for enhanced collateral fluidity?

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Source: Asset-Encumbrance-Apr14.pdf

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