Liquidity in the European government bond market has returned to levels from before the Covid-19 pandemic, but it could be improved further. The biggest barrier to this is the heavy regulation and balance sheet constraints that have been imposed on financial institutions since the financial crisis of 2008.
Liquidity was a central topic of discussion at the European sovereign, supranational and agency forum hosted by OMFIF’s Sovereign Debt Institute in Luxembourg. This exclusive event brought together leading European sovereign debt management offices and issuers, along with banks, investors and other market participants, to discuss the key issues facing this market.
One head of a western European debt management office said at the forum that liquidity levels were back to around 2019 levels, but the regulation of banks was a key factor in hindering even stronger liquidity conditions in the European government bond market. He said that, while greater regulation in the wake of the financial crisis had ‘brought a lot more solidity to the banking system’, it had also ‘moved part of the risk from the banking system and intermediaries to the markets’, which has affected the level of liquidity.
‘In this respect, an analysis of how some of these regulations should be adjusted is probably worth looking at,’ he added.
Bankers at the forum echoed the impact of bank regulation on the ability to provide strong levels of liquidity in the European government bond market.
‘If you look at the growth of the European debt markets, in particular the government bond market, we’re talking about 130% since the financial crisis,’ said a head of SSA debt capital markets. ‘That is basically an average growth rate of 7% per year. At the same time, the collective balance sheet that is committed to trading this debt has, at best, remained constant but in many cases, it has actually declined.’
An SSA debt capital markets head said regulation was the reason liquidity provisions from balance sheets had not kept up with the growth of the European government bond market, highlighting the leverage ratio of banks. ‘The most painful is the leverage ratio, which is a very crude measure that does not differentiate between the riskiness of your assets on the book,’ he said.
It does seem odd that, as a business opportunity grows, banks are being forced to cut back on their ability to take advantage of it. This has particularly affected banks with smaller balance sheets, causing them to quit their roles as primary dealers. ‘Overall, the cost of regulation and complying with regulation has set a very high barrier for small institutions to be active,’ said the banker. ‘Trading government bonds is not profitable enough for them anymore’.
Another DCM official echoed these concerns. ‘Warehousing is becoming a lot more expensive. Regulation is really becoming a problem for us, whether it’s the leverage ratio or incremental risk capital models that are being introduced,’ he said.
As a result, banks are stuck between trying to serve both regulators and issuers. ‘We find a disconnect between our clients at the DMOs asking us to provide more liquidity but, on the flip side, the regulators are putting more costs on providing that liquidity,’ said the DCM official.
Another option to overhaul the regulation of banks is to allow non-banks, such as hedge funds and fast money accounts, to enter the European government bond market as primary dealers. In a poll of attendees at the OMFIF forum, 70% said this was a good idea to boost liquidity in the market.
Currently, only financial institutions with a banking licence can act as primary dealers in the European government bond market. However, hedge funds have been boosting their involvement with the US Treasury market since the financial crisis as traditional banks have pulled back due to heavy regulation. Hedge funds are now an essential part of the US Treasury market in providing prices and market-making activities. The European government bond market could take note.
Burhan Khadbai is Head of Content of the Sovereign Debt Institute at OMFIF.