FI Analysis 3: Liquidity in the market for covered bonds

2015-12-01 | Reports Markets Bank

The market for covered bonds is important for bank funding and therefore financial stability. The requirements for banks to hold more capital and liquidity for their operations have been tightened since the financial crisis. These requirements affect the banks' costs of holding securities in the trading book and so their costs of acting as market makers.

Market makers play an important role in supporting market liquidity. Market liquidity in turn affects funding liquidity. In theory, higher capital and liquidity requirements should reduce
market liquidity, and market participants are attesting that this has in fact happened.

Finansinspektionen (FI) has therefore studied market liquidity for covered bonds using unique transactions data. The selected measure of liquidity, the yield impact, reflects the change in yield to maturity that can be observed between two transactions carried out on the same day for a specific bond. Our results show that this form of liquidity has been unchanged in recent years. We also find that there is a strong correlation between market liquidity in covered bonds and government bonds.

On average, the transaction cost for covered bonds has been just under 2 basis points over the past few years. For government bonds it has been about 1.3 basis points. The fact that this has remained constant for several years despite increasing legal requirements on banks' capital and liquidity does not necessarily mean that the higher requirements have not had any impact, but it may also be due to these possible negative effects having been offset by the Riksbank's increasingly expansionary monetary policy.In case monetary policy was to be normalised, there might be a risk of deterioration in market liquidity.