03 April 2012

Risk Net: Banks' long-term funding needs will drive demand for liquidity swaps with insurers

The UK market for liquidity swaps between banks and insurers is anticipated to grow, following the publication of the Financial Services Authority's (FSA) guidance on the transactions, despite the current availability of cheap funding from the European Central Bank (ECB), bankers predict.

The market for liquidity swaps dried up last year after it emerged that two liquidity swaps were blocked by the FSA, amid concerns these transactions led to systemic risk by increasing the interconnection between banks and insurers. Following a consultation, the FSA published guidance on the governance of liquidity transactions.

Bankers expect the permissive stance taken by the FSA's guidelines will mean more transactions taking place, despite suggestions that demand has weakened as a result of the cheap funding available through the ECB's long-term refinancing operation (LTRO). To access the LTRO scheme, banks pay a 1 per cent fixed rate, while a liquidity swap with an insurer might cost significantly more, depending on the rating of the bank, the nature of the collateral and the tenor of the trade.

But loans through the LTRO scheme must be repaid in three years' time, which will make liquidity swaps with longer tenors attractive as banks look for stable long-term funding, bankers say.

"There may be some reduction in immediate demand for secured funding by LTRO-funded banks, but the ECB will require repayment of the loans in 2015, and banks will need to ensure they have other stable means of funding themselves beyond this. Therefore, the liquidity swap market should continue to grow", says Sam Taylor, senior structurer in the alternative funding group, fixed income, at BNP Paribas in London.

Liquidity swaps are executed for tenors longer than three years to match the needs of pension funds and insurers and, as such, will still be attractive for banks, which will need to manage their funding duration, Taylor adds.

The introduction of Basel III for banks and Solvency II for insurers could also provide further incentive for liquidity swaps. Basel III will increase the liquidity requirements on banks, while the current calibrations of Solvency II are favourable to liquidity trades.

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