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A relaxation of the Basel III liquidity requirements for high-quality corporate bonds could help underpin demand for this asset class in the medium term, said Fitch Ratings. However the proposed framework's rating-based eligibility standards - if not changed - would limit the impact of any loosening to the small stock of corporate bonds rated AA- and above.

Fitch believes this rating bar could in theory be moved downwards to capture lower-rated but ultimately more liquid instruments, if criteria focus on factors that influence liquidity more than credit ratings do. Ratings, never intended to measure market risk, are an increasingly weak indicator for the market liquidity of bonds themselves, as opposed to the liquidity of the obligor issuing the bonds.

Basel III liquidity rules require banks, from 1 January 2015, to "hold a level of unencumbered, high quality assets that can be converted to cash to satisfy their liquidity requirements for a 30-day time horizon under a severe stress scenario." This requirement is measured as a liquidity coverage ratio comprising the stock of high-quality liquid assets divided by net cash outflows over 30 days under the stress scenario.

"High quality assets" can currently include corporate bonds rated AA- or above, but require a minimum 15% haircut. Corporate bonds are additionally classified as Tier 2 assets, which can only make up, post-haircut, 40% of a bank's total liquid assets. Were the Basel committee to relax its rules regarding corporate bonds, as has been widely reported, Fitch would expect it to do so through one of these measures. This would - all else being equal - increase demand for corporate bonds.

Europe's transposition of the Basel III directive into law - set out in the Capital Requirements Directive IV proposal - may alter some of these parameters for European banks including extending the cap on Level 2 assets to 50% and taking a more sophisticated approach to haircuts.

Basel III's existing rating criteria greatly limit the number of corporate bonds that could be held, so their relaxation is fundamental to the magnitude of any impact. Only 14 corporates in Europe, Middle East and Africa (EMEA) are rated AA- and above, a number which has fallen in recent years as companies - mainly in the utilities sector - have chosen to migrate down the ratings scale. Companies rated AA- and above accounted for only 17% of total corporate issuance in 2010.

Lowering the rating requirement would not necessarily result in any degradation in the liquidity properties of the bonds held. Corporate entity ratings - issuer default ratings (IDRs) - reflect relative probability of default only. Issue ratings also factor in recovery given default. Neither addresses market liquidity of bonds. The bonds of a small AA rated issuer with a single €50m bond outstanding will typically be less liquid than the bonds of an A rated issuer with €10bn of bonds.

The past few weeks have illustrated how liquidity reflects the intangibles of market sentiment. The feedback Fitch has received from investors is that liquidity for corporate bonds in the secondary market - still seen as a relatively safe haven by many - is very weak in response to currently elevated levels of market uncertainty. In particular, market makers in the bank community have substantially reduced their inventory, and hence their ability, to make a liquid market for corporate bonds.

Critically, for assessing market liquidity of bonds the regulations would be better served by focusing instead on the alternative liquidity measures set out in the Basel III liquidity framework. These include the presence of a large, deep and active repo or cash market, and past price performance in times of stress.

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