Official institutions lead the Covid‑19 recovery charge

Tested by the Covid-19 pandemic, market consensus is that official institutions have been instrumental in mitigating market disruption. As economies work out how to adapt to a post-lockdown world, major public bodies are likely to play a key role in the economic recovery process. BNP Paribas Securities Services’ Christian Oger and Andrew Geggus examine how these institutions are expected to support economic growth in the new normal.

A massive monetary policy response

The intervention by the European Central Bank (ECB) to mitigate the economic damage caused by Covid‑19 has been extraordinarily powerful. In addition to pumping vast amounts of liquidity into eurozone banks, announcing an interim lowering of bank capital requirements and postponing European Union-wide stress tests until 2021, the ECB has introduced a temporary easing of its collateral measures – in effect, reduced haircuts, widening the scope of acceptable bonds and loans – to help banks continue to provide liquidity and credit. The ECB also strengthened its quantitative easing (QE) programme through the €1.35 trillion Pandemic Emergency Purchase Programme (Pepp), a scheme expected to last until at least the end of June 2021.

The ECB has demonstrated increased flexibility and some risk tolerance over the past four months. Most notably, it included Greek government bonds in its bond-buying list and scrapped a self-imposed limit on holding more than 33% of any one country’s bonds. The ECB also expanded the range of eligible assets and maturities by incorporating non-financial commercial paper and government bills into its QE programme. 

Although the ECB and the US Federal Reserve have reacted quickly to the Covid‑19 crisis, their responses have diverged at times, owing mostly to the structural differences between both markets. Whereas banks in Europe have traditionally been the providers of corporate financing, funding in the US is typically procured through capital markets. This explains why the ECB provided ample liquidity to the banks, while the Fed set up a panoply of primary and secondary corporate purchases, going beyond the initial purchases via indexes such as exchange-traded funds.

The nuances of the Fed’s and ECB’s responses are also a consequence of both markets being at different stages of the economic cycle at the start of the crisis. The Fed, for instance, reduced interest rates to 0–0.25%; the ECB’s were already set at zero. Another inconsistency between the two central banks is that the ECB has publicly disclosed how much it intends to purchase as part of the Pepp initiative, in contrast to the Fed, which instead conducted an open-ended asset purchase programme. 

Covid-19: a catalyst for social bond issuance

As markets stabilise, there is growing pressure on central banks worldwide to ensure corporate QE is reserved for sectors making tangible environmental, social and governance (ESG) improvements. Admittedly, this may prove difficult in some cases, especially as a number of bond-buying programmes do not allow central banks to discriminate against particular industries.

However, there are a number of reasons to be optimistic about the future trajectory of ESG. First, central banks appear to be adopting a co-ordinated, structured approach in the fight against climate change through consortia such as the Network for Greening the Financial System, a body that has continued to grow its membership since its inception. 

Similarly, there has also been a notable spike in demand for social bonds amid the current crisis. These now account for 28% of the total sustainable bond market, with issuances climbing to $33.1 billion during the first four months of 2020 – a trend driven largely by supranational bodies and agencies. In contrast, social bonds comprised just 5% – or $14 billion – of the sustainable bond market last year.

Use of proceeds from many of these social bond issuances are being funnelled into initiatives designed to mitigate the impact of Covid‑19. High-profile issuances include the International Financing Corporation’s $1 billion three-year social bond designed to fund Covid‑19 relief measures, the African Development Bank’s $3 billion three-year Fight Covid‑19 social bond aimed at providing support and financing to African countries and businesses, the European Investment Bank’s €1 billion eight-year and €1 billion 10-year Sustainability Awareness Bonds, and the Nordic Investment Bank’s €1 billion three-year Inaugural Response Bond. These issuances will attempt to alleviate the social and economic consequences of the Covid‑19 pandemic. Nearly all of these transactions follow the International Capital Markets Association (ICMA) Social Bond Principles, a set of guidelines promoting transparency in the social bond market.

Social bonds have grown in size and popularity, with $57 billion issuance in 2020 year-to-date versus $9 billion during the same period last year. Green bonds represent $93 billion year-to-date, suggesting interest in these products remains very healthy, although a little behind the 2019 year-to-date issuance at $111 billion. Sustainability-linked bond issuance activity is also projected to rise in the wake of the sustainability-linked loans, which have seen exponential growth since their appearance only a couple of years ago. 

The ICMA Sustainability-Linked Bond Principles should help pave the way for the development of this new market. Global regulation promoting ESG is also expected to support more issuance. The EU, for instance, is pushing ahead with its Sustainable Finance Action Plan, a policy intended to help steer private and public funding into ESG investments. Other core markets are now following suit. 

Securities lending and repo

Cash injections by central banks have been critical in stabilising the repo market –especially during the early stages of the Covid‑19 disruption when investors were struggling to manage their liquidity risk. This rapid intervention by central banks ultimately freed up financial institutions’ credit lines, allowing for cash to be deployed in the repo market. This decisive action is widely considered to have prevented a severe drought in credit markets. 

The demand for high-quality liquid assets and the use of those assets to generate incremental revenue in a risk-controlled programme have always been present in the market. The volatility over the past several months has shown that central banks have an opportunity to earn increased returns while adding liquidity to capital markets through the adoption of securities lending programmes. 

Revenue opportunities are also available as a result of incoming over-the-counter (OTC) derivatives regulation in the US, EU and Asia‑Pacific. Having implemented mandatory clearing of vanilla OTCs through central counterparties, global regulators are pushing ahead with reforms that will require counterparties to bilateral OTC transactions to post initial and variation margin on their trades. Although the rules have been delayed by one year due to Covid‑19, trading counterparties must still obtain acceptable collateral to post as margin. Not all financial institutions will have suitable collateral available in their inventories, so must source it from elsewhere. Official institutions – a number of which are sitting on massive liquid cash reserves or high-quality financial instruments – may be tempted to on-lend some of their securities to OTC market participants, which will use them for margining purposes. 

As a leading global provider, BNP Paribas Securities Services is in a strong position to support clients’ securities lending requirements by providing global and local coverage in more than 30 countries for a wide range of asset classes and using different types of collateral. It offers various routes to market, including both principal and agency lending services, while clients can simultaneously access the bank’s industry-leading Global Markets and CIB facilities. The breadth of services enables participants to be well positioned to maximise revenue opportunities while minimising market exposure. Coupled with its robust asset safety measures and commitment to risk management, BNP Paribas Securities Services can provide an optimum securities lending solution to official institutions. 

Delivering unmatched programme value to central banks has long been a priority for BNP Paribas. This focus has strengthened BNP Paribas’ role as a leading provider of securities lending services to central banks – as acknowledged by Central Banking Journal, which recently recognised the bank as winner of its 2020 Specialised lending initiative award.

Reassessing priorities post‑Covid‑19

Covid‑19 is a crisis like no other. Official institutions – including central banks – will be vital in shaping the world’s recovery moving forward. From short-term monetary intervention as a means to shore up liquidity to longer-term initiatives focusing on ESG bond issuance, official institutions are helping to salvage the global economy.

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