Policy on the asset side again March 13, 2011 at 9:57 am

The FT last week had an article about exactly what I meant in my earlier post. They said:

UK pension funds are urging the government to issue more long-dated and inflation-protected gilts to help them deal with increasing life expectancy of members and regulations that put pressure on the to “de-risk” investments”

The result of not acceding to this request is clear: without a supply of the real thing, banks will attempt to create it using a combination of swaps, credit derivatives, and whatever bonds they can find. Meanwhile long dated gilt yields, both nominal and real will be lower than market levels due to unmet demand. This is not a good situation: it leaves pension funds with both more basis risk and more counterparty risk than they need, and it leaves pensioners with less return. The DMO should not just be saying ‘how many long-dated gilts do we need to issue?’ but rather ‘how many does the market want?’.

Update. Here is another example of the same phenomena, from a discussion by Bronte Capital of 77 bank in Japan.

In a world where banks everywhere are short of capital 77 bank is swimming in it. [Their Tier 1 ratio was over 12%.] … This bank has an embarrassment of riches – and nothing to do with them.

As John suggests, Japan is a great example of what happens if you keep rates low to ‘save’ the banking system and pay no attention to the needs of investors. Capital sits in places like 77 doing nothing rather than being distributed to economically productive users of it. And that is bad for everyone.

Comments are closed.