Basel capital requirements and sovereign bond demand

This is the second post of this short series reviewing recent research on the distortions introduced by the Basel banking framework, in light of the ‘RWA-based ABCT’. Two days ago I focused on the influence of capital requirements on mortgage pricing. Today I’m going to focus on a new quite interesting (albeit predictable?) piece of research that looks at the influence of the Basel framework on the demand for government bonds (see Preferential Regulatory Treatment and Banks’ Demand for Government Bonds by Clemens Bonner, see also Voxeu summary article here).

Bonner not only analyses the effects of capital requirements, but also of liquidity requirements, mostly introduced by the post-crisis Basel 3 accords. His dataset comprises Dutch banks (which were subject to a Dutch equivalent to Basel 3’s Liquidity Coverage Ratio, the ‘DLCR’). To identify whether banks’ demand for government bonds is caused by regulatory or internal risk management effects, he hypothesises that a change in demand around reporting date is likely to imply that regulatory reporting is the main driver.

He first looks at the impact of liquidity rules (the x-axis represents days of the month, and increased demand for the asset is represented by a descending curve):

If a bank’s regulatory liquidity position affects its net purchases of government bonds over the entire month, it cannot be established whether this effect comes from regulation or from internal risk management targets. With the DLCR affecting banks’ net purchases only from day 18 onwards, it can be concluded that there is limited evidence of an internal effect incentivizing banks with lower liquidity holdings to purchase more government bonds or sell more other bonds. The combined evidence of the DLCR affecting banks’ demand only towards the end of the month and the slopes presented in Figure 5 show clear signs of a regulatory effect, suggesting that the DLCR incentivizes banks to substitute government bonds for other bonds.

He then applies the same logic to capital ratios:

Similar to liquidity, Figure 6 shows that the regulatory capital position is an important determinant of banks’ net purchases of government bonds. One can see that a lower regulatory capital ratio in the previous month causes banks to buy considerably more government bonds and sell more other bonds.

He concludes:

Our results suggest that preferential treatment in microprudential capital and liquidity regulation increases banks’ demand for government bonds. On top of that, it seems to cause a substitution effect, with banks buying more government bonds while selling more other bonds. Further, we find suggestive evidence that this “regulatory reaction” reduces banks’ lending.

As expected, it’s pretty clear that sovereign bonds, thanks to their preferential regulatory treatment (no capital required and quasi-obligation to hold them as part of your high-quality liquid assets portfolio) boosted the demand for them. This, in turn, should have depressed their yields and allowed governments to benefit from lower interest rate than in an unhampered market. Low yields are always good for debt binges.

Worse, and also as expected, the increase in demand for those bonds led to a decrease in demand for corporate bonds, which is likely to have had the opposite effects on yields and on the profitability and investments of those firms.

PS: I think I should rename the ‘RWA-based ABCT’ into ‘Basel ABCT’. The RWA name was mostly valid in pre-Basel 3 times but now that Basel 3 has introduced extra ways of distorting demand, supply and yields, ‘Basel ABCT’ sounds more appropriate.