With bank profitability under pressure, and the possibility of interest rate rises adversely impacting the value of fixed income portfolios, active management of risk premia offers a way to optimise HQLA pools’ returns.Bank treasurers appear caught in a conundrum. .
On the one hand, Basel III’s banking reforms force them to hold far more capital than ever before. On the other, record low interest rates mean they earn little return on this. Yet if treasurers apply advanced asset management techniques to their pools of “high-quality liquid assets” (HQLA), we believe that they can enhance risk-adjusted returns significantly. One of the key elements of Basel III is the Liquidity Coverage Ratio (LCR), which requires banks to hold a certain percentage of their potential 30-day outflows in HQLA.
While the LCR ensures that banks have sufficient liquidity at times of market stress, it drives them to hold sovereign bonds with low or negative yields. With many European banks struggling with profitability anyway, this is a further unwelcome pressure. But by applying sophisticated investment management techniques, we believe treasurers could add up to 50 basis points per year to returns, with benefits for profitability. They could also reduce the risk of volatility triggered by interest rate rises. What treasurers must master is the active management of risk premia.
A risk premium is the amount of return over the risk-free rate investors require for holding a risky asset. As investors are risk averse, a risk premium should exceed potential losses from the risk. We see four risk premia that banks can benefit from