The price of assets regarded as safe is on the rise, with supply dwindling and demand rising amid uncertainty in financial markets, regulatory reforms, and increased demand from central banks in advanced economies.

Growing demand and shrinking supply of safe assets—typically predominantly government bonds—could have negative effects on global financial stability, according to the IMF’s latest analysis in the Global Financial Stability Report.

To make sure these pressures don’t destabilize financial markets:

• reforms of financial regulation should gradually seek to differentiate better across assets based on underlying risks;

• governments in danger of losing their securities’ safe asset status need to place themselves on a sustainable debt path;

• The private sector should be encouraged to issue safe assets following transparent and sound methods.

The global economic crisis and rising government debt concerns in some advanced economies have shown that no asset can be viewed as truly safe, the IMF said.

Absolute safety—implicit in credit rating agencies’ highest ratings and embedded in financial regulations and investor mandates—created a false sense of security prior to the crisis.

Demand on the rise, supply scarce

Before the crisis, the excess demand for assets categorized as safe was driven by booming emerging economies that had accumulated reserves and used these to buy large amounts of safe assets.

Now, the demand for safe assets faces pressures due to new financial regulations that require banks to hold more safe assets; higher collateral needs for over-the-counter derivatives transactions or their transfer to centralized counterparties; and the increasing use of safe assets in monetary policy operations, such as purchases of government securities by central banks, according to the IMF.

On the supply side, concerns about high government debts and deficits in some advanced economies have reduced the perceived safety of government debt. Recent rating downgrades of sovereigns, previously considered to be virtually riskless, show that even highly-rated assets are subject to risks.

The number of sovereigns whose debt is considered safe has fallen. IMF estimates show that safe asset supply could decline by some $9 trillion—or roughly 16 percent of the projected sovereign debt—by 2016. Private sector issuance of safe assets has also contracted sharply on poor securitization practices in the United States.

Safe asset scarcity will increase their price, with assets perceived as the safest affected first. Investors unable to pay the higher prices would have to settle for assets that have higher levels of risk.

Spikes and shortages

Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs.

For banks, the preferential treatment of sovereign debt in banking regulations can allow more leverage to build up. The upward bias to capitalization ratios can lead to an overestimation of the buffer available to meet pressures during a time of stress. Under current regulations, banks’ holdings of debt issued by their own governments—and in the case of the European Union, of the debt of any sovereign in the Union—are commonly assigned zero risk weights.

Risk weights are adjustments, based on the riskiness of assets, for the purpose of determining how much capital banks should hold. When these are set at zero, banks can hold government debt without any required capital to cover potential losses associated with such holdings.

Policies can help supply and demand pressures

The IMF said policy responses to the pressures in the markets for safe assets should be implemented gradually to avoid unnecessary volatility in the prices of some assets.

The IMF also pointed out that to mitigate pressures on the demand side, regulations and policy responses should differentiate better across assets based on underlying risks. The categorizations of assets based on risk should be reviewed at regular intervals to ensure that they reflect adequately such risks. Specifically:

The IMF stressed that credible plans to reduce government debt levels and strengthen debt management over the medium term would help increase the supply of safe assets. However, where financing conditions allow, the near-term pace of reducing government debts and deficits needs to be mindful of the dampening effects on economic growth.

The private sector could once again become a key supplier of safe assets. Sound reforms and effective regulations would be needed to govern the pooling of various types of lower-rated contractual debt into higher-rated financial instruments, for example through securitization.

The build up of the capacity of emerging economies to issue their own safe assets with the improvement of domestic financial infrastructure would also alleviate the imbalances in the global markets for safe assets.

While the “price of safety” will inevitably rise, a smooth adjustment process can be ensured if policymakers are aware of their actions and their potential consequences.