Collateral scarcity and asset encumbrance: implications for the European financial system

In the financial sector, there is increasing demand for high quality collateral assets that combine liquidity with low credit risk. This is fuelled by greater risk aversion since the onset of the global financial crisis in 2008 and by regulatory initiatives such as collateral requirements in derivatives markets and liquidity requirements for banks. In turn, increasing collateral use is boosting the share of encumbered assets on banks’ balance sheets. This may have adverse implications for the financial system. Collateral use adds to complexity, opacity and interconnectedness between financial market participants. Asset encumbrance also reduces the scope for bail-in given less residual assets for unsecured creditors. Beyond this, increasing collateral use exacerbates procyclicality stemming from haircuts, margin requirements and collateral eligibility. Taking a European perspective, this article maps out the recent rise in collateral demand and asset encumbrance, investigates the implications and sketches policy options, including greater transparency, prudential limits, better guarantee pricing and tighter risk management practices.