Basel III: Bullish for Bonds

Sep.13.10 | About: iShares Core (AGG)

We would like to begin by emphatically stating the new Basel III regulatory requirements are a very positive step for the stability of the global financial system. At the core of any successful capitalistic system is confidence, the new Basel III rules will go a long way in restoring that confidence.

That being said we see a tradable flaw in the assumptions of the Basel III creators. The implicit assumption is the phase-in period will allow banks to grow capital without hurting the economy. We wholly disagree with this assumption – since many banks, especially US banks already meet requirements, in order to remain competitive, banks will immediately raise capital levels and probably above the minimum. Moreover systematically important banks need even more capital – we do not believe this is priced in by the market and remains a HUGE unknown and a weak link.

The structure of the new rules require that Tier 1 Capital be 7% of risk weighted assets; in formulaic terms – Tier 1 Capital / Risk Weighted Assets = 7%. In our view, the markets are too focused on the numerator and have ignored the denominator. To adjust for risk weightings, bank assets are assigned a rating from 0 to 100, with 0 being the “safest” assets like government bonds and 100 being the riskiest of assets.

As designed, the riskier the assets a bank holds the more capital its needs – this is logical and desirable. In our view, instead of raising capital, banks that need to boost their ratio have an incentive to shed risky assets and buy government bonds. In fact, this may be the quickest and easiest to comply with the new guidelines.

Moreover, the market is not focused on the one line that states systematically important banks will require even more capital. From the press release:

Systematically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue…

We view all of the large cap US banks as systematically important and therefore believe US banks now have an incentive to increase their holdings of Treasury securities.

bonds to loansClick to enlarge

(Click to enlarge)

The chart above shows the percentage of US government securities held by banks relative to the amount of loans and leases (a proxy for risky assets). Throughout the 1940s and 1950s banks held as much as 2.5 times as many government securities as loans. As credit became ubiquitous banks held fewer government securities, ultimately reaching the lows around 15% in 2007. Since then banks have increased the percentage of government securities to 22%.

We present this chart to illustrate that banks currently hold some of the lowest amounts of government securities relative to loans in the last 60 years. Implicitly this means banks have plenty of room on their balance sheet for more government securities. As a reference, if banks simply wanted to achieve levels last seen in the 1990′s of 30% then they would need to buy ~$500 billion in government securities…now that’s QE!!!

We are initiating a long position in TLT in anticipation of US banks increasing their holdings of US government securities.

Disclosure: Accounts Managed by Kanundrum Capital are Long TLT