It is an old story. But an instructive one that bears repeating. When markets collapse, investors head for safety into assets that they believe fulfill the following three conditions:

  • Must store value over time
  • Must be liquid when traded
  • Must not depreciate, naturally or otherwise. 

The greatest, and historically favoured, asset of all time - from Roman Emperors to villains in James Bond movies - has been gold. In late 2009, this column had written extensively on how gold prices were headed northwards because of, not just, increased economic uncertainty due to the credit crises but also due to possible fears about sovereign solvency in Europe.

Notwithstanding the fact that gold is often, and rightly, dismissed by many - including Nouriel Roubini - as a barbarous relic, it's longevity is a sign of how difficult it is to find a reliable asset to store value. [At its extreme, this rationale implies if an asset perfectly fulfils all three criterions, it contains no risk. No risk means an absence of volatility in how investors' perceive its value. The result is that there is no profit or loss to be made.]

In the financial world, the closest one saw such ‘risk-less'-ness was in the sovereign securities market. Particularly, the bonds, notes and bills issued by countries like the United States, with a strong tax base. The demand for these risk-less assets rose and fell as a counterpoint to the irrational exuberance of markets. This demand-supply was a dynamic that market forces dictated.

Yet, today there is a new creator of demand in the world of ‘risk-less' assets. A set of modified regulatory rules that seek to improve the "safety" of the global financial architecture called Basel III is to be implemented from 2013 until 2018. The ostensible rationale behind Basel III regulations is the claim that banks need to shore up on "safer" assets in their portfolios.

The real reason is that Basel II regulations didn't help to avert, reduce the impact or even mollify the credit crises. So, to wit, more regulation by pushing risk out of the banks (into the unregulated hedge fund space) will supposedly make the world safer. What must be said is that much of the sovereign crises that we see today can be traced to the inadequacy of banks' capital reserves during the credit crises.

Compliance with Basel III regulation has specific requirements on how much capital banks have to keep on their books as protection. This capital requirement is contingent on principally two classes of assets called Level 1 and Level 2.

Here Level 1 comprises of, amongst other assets, government bonds issued by AAA rated countries that are assumed to be of zero risk. Add to this group, those bonds issued by governments with AA- or less rating, as long as the banks have the same domicile as the issuer.

In contrast, Level 2 assets include riskier bonds and corporate issues. So, if the bank's balance sheet contains inordinate amount of Level 2 assets - these will be discounted and a haircut will be applied. The result would be that only 40 per cent assets in the final calculation of the Liquidity Coverage Ratio would be from Level 2.

In contrast to the highly leveraged and debt ridden countries of the core-and-periphery of Europe, many countries continue to have a unique problem where there aren't enough bonds issued by their governments.

Most prominent are medium sized industrialised economies like Australia, Canada, Denmark and Norway which have small local corporate bond markets, compared to the needs of their banks to shore up Level 1 capital.

An interesting study by Basel III committee concluded that had the banks been expected to follow the regulations in 2009 - there would have been substantive shortfall in "safe" assets. Basel III expects banks to have nearly 7 per cent of their capital ratio (defined as capital to risk-weighted asset) to comprise of Tier 1 assets.

Based on this level, per Basel III officials themselves, the world's top 94 banks would have fallen short of $768.7 billion. This is a ‘what-if' exercise, but one that reveals the impending scramble to find quality collateral.

The result is that there is a gradual pressure to find ways around it. One obvious suggestion is that banks be allowed to hold non-domestic government bonds. The argument against this is that foreign exchange risk might transmit through the cross-currency swap markets; and thus subvert the original cause of creating this regulation.

The other suggestion is that governments may issue more debt, albeit exclusively reserved for capital requirements. What is to be done with the proceeds of such an issuance is unclear! A third proposal is to allow assets like "covered bonds" - a sort of asset backed security that forces the issuer to provide the underlying pool in case of default - into the Level 1 & 2 capital requirements. In response, some argue - such covered bonds are all smoke and mirrors and prone to abuse as they were during the credit crises thanks to the ratings agencies.

In short, what we are likely to see in the coming days is a scramble for "safe" assets. Yields for such assets will only continue to fall as their price and demand rises. In more ways than one we are back to 2009-like trying to stay "safe". Only this time, it is regulation that stipulates what "safety" means. 

The columnist manages risk on credit derivatives portfolios for an investment bank in New York City. On Twitter he is at @ks1729. All views expressed here are personal and do not reflect views of co-authors or affiliated institutions.