Liquidity rules to boost demand for gilts

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New regulations to help banks withstand sudden financial shocks are likely to boost the government bond markets.

Although the markets did not react to the Financial Services Authority’s announcement yesterday, it will underpin them over the coming years.

The FSA’s move will require banks to increase holdings of highly liquid government bonds by £110bn.

Traders avoided knee-jerk buying as the banks have years to comply with the proposals. Most UK banks are likely to buy gilts in order to avoid currency risk.

Analysts welcomed the FSA decision, even though it will hit the banks’ profits, because it means sacrificing higher yields on riskier assets to buy safe government stock.

The banks have the option of buying sovereign bonds, other than gilts, and those issued by safe, highly-rated institutions such as the European Investment Bank, the financing arm of the European Union.

John Wraith, head of sterling rates product development at RBC Capital Markets, said: “Most banks have probably bought gilts in anticipation of the FSA decision. It is also a move that will be welcomed by the market. It is sensible that banks build up their liquidity reserves as it makes them better able to withstand any future financial shocks.”

Yields on two year gilts remained steady around 0.71 per cent, while yields on 10-year gilts traded in a tight range around 3.39 per cent. Traders said banking stocks were also unaffected by the announcement.

The assets that come under the programme must be highly liquid. In the aftermath of Lehman Brothers’ collapse, many banks were hit by the drying up of liquidity, with debt instruments on their books that proved impossible to sell.

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