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EBA misses crucial disclosure on asset encumbrance reporting

The European Banking Authority’s effort to improve transparency on balance sheet encumbrance has come to nothing. The draft guideline, which will be finalised by June, is practically useless because it doesn’t include emergency central bank liquidity which is the largest and most important source of encumbrance. But that’s probably just as well, for if this disclosure became public knowledge, it would create just the sort of negative feedback loop that brought down the UK’s Northern Rock.

In May last year the Bank of international Settlements suggested regulators should seek to limit the level of balance sheet encumbrance. The BIS said it was concerned that high levels of asset encumbrance would cause the risk-sharing burden to be unduly tilted towards unsecured creditors.

The EBA subsequently held a public consultation on the topic with the aim of drawing up reporting templates. By improving transparency, the EBA was probably hoping that issuers would think more carefully about how they encumber their balance sheets. By improving transparency, supervisors would be in a better position to assess an institution’s ability to deal with stress and show the assets available in the event of its resolution.

However, the EBA’s draft guidelines for encumbrance reporting leaves out the most vital disclosure of all which is the emergency liquidity provided by central banks. “The proposed requirements means that unencumbered assets disclosed might not actually be available for funding purposes,” said Fitch last week.

Paradoxically, as Fitch says, the likelihood of unreported central bank support increases as liquidity risk rises. Without this key information the EBA’s efforts are practically useless.

But this is probably just as well.

The is because disclosure of emergency central bank funding is certain to create precisely the same negative feedback loop that brought Northern Rock to its knees.

Lenders that are seen to be using higher proportions of central bank liquidity would quickly find that their counterparties would request more collateral against their credit lines and at a steeper rate. Faced with a liquidity squeeze, lenders would have no other choice than to seek further emergency liquidity.

The disclosure of central bank assistance had dire consequence when, in September 2007, the Bank of England chose to issue a statement saying that Northern Rock’s Granite 2007-03 RMBS was retained and “could be utilised as eligible repo collateral”.  

Within hours the bank’s share price collapsed, panic ensued and a few months later the stricken issuer was taken into public ownership. 

So, it’s perhaps just as well that this critical measure of liquidity is not publicly available. But at the same time, it’s doubtful that its deliberate exclusion really makes the world a safer place.

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