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Basel III And Its Impact On Bond Trading

BASEL III came into picture as an aftermath of global credit crisis that started in year 2007 in the U.S. It is essentially a set of regulatory standards that are targeted towards a bank's capital adequacy, stress testing and market liquidity risk. It was introduced upon by the members of the Basel Committee on Banking Supervision in 2010-2011, and is now scheduled to be implemented by 2019. In short, the rule requires banks to hold 4.5% of common equity (Basel II: 2.0%), maintain Tier I capital of 6.0% (Basel II: 4.0%) and specify several other capital measures such as capital conservation buffer, minimum total capital etc. Based on systemic importance of a bank, it may be required to hold additional equity buffer in the range of 1.0% to 2.5%.

In addition to capital rules, BASEL III also talks about liquidity requirements through minimum liquidity coverage ratio and net stable funding ratio. Of these two, our interest lies with liquidity coverage ratio. As defined by the guidelines, the liquidity coverage ratio (LCR) will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario. LCR implementation is expected on 01 January 2015, but the minimum requirement will begin at 60%, rising in equal steps of 10 percentage points to reach 100% on 01 January 2019.

For fixed income analysts, the word "high-quality liquid assets" becomes an intriguing point. At this point, it can be said that the requirement to increase high-quality liquid asset is expected to increase the demand for "A" rated papers or bonds. Among the top three credit rating categories, AAA, AA and A, the market for "A" rated paper is the largest in size. At this point, your financial advisor could be telling you that on account of the implementation of BASEL III, the demand for top rated paper and other papers across the rating spectrum could go up. In a scenario, where banks are expected to snap up top-rated papers to boost their liquidity ratio, the bonds rated below "A" in the investment grade as well as those in the non-investment grade category could benefit on account of their relatively better yields. So today, if you think that the yields are at historically low levels - then imagine where they can possibly reach tomorrow with the implementation of liquidity ratio. On the other side of coin, in a real distressed situation, the market for even A rated papers cannot be assumed as liquid as sovereign papers. It has been a time tested fact that when tough time comes, investors tend to pile into high rated government papers despite low or negative rates offered by such securities during risk-off periods. Nevertheless, in a normal scenario, we do deny some benefits for the bond trading as discussed above. Therefore, yields could go down further.