Banks hold many types of assets on their balance sheets; some risky, some less so. The greater the risk, the greater the expectation of high returns. These days, however, risky assets are increasingly illiquid, and that is a problem, because banks need to deploy their assets to generate cash.

Cash is the lifeblood of any bank, and the current shortage is providing pension schemes with an opportunity to use their capital to step into the breach. Until recently, this securitisation process was used extensively by banks to realise the value inherent in their portfolios of assets, including illiquid assets. Alternatively, it was used to fund illiquid assets using unsecured debt via a bank's own balance sheet. However, the market dislocations and liquidity crises of 2007 and 2008 have significantly reduced the volume, scope and price efficiency of such techniques. Investors now require protection against a fall in the value of the underlying assets, as well as a guarantee to make good any shortfall. Imminent regulatory changes mean that many assets now attract a high risk weighting, requiring banks to set aside significant capital if they want to hold risky assets. In other words, the costs to the bank in respect of that particular asset are now greater than the return it yields. This is known as a "negative carry" and is simply unsustainable for any period of time. The extreme difficulties facing banks in raising cash to lend have ushered in a new genre of liquidity providers: pension schemes. This is because, although they need to hold assets to pay benefits in years to come, they do not, as a general rule, need to have immediate access to the high liquidity associated with some of those assets. Top-rated government bonds, for example, are both safe and liquid but, as a consequence, offer a low yield. Pension schemes often hold significant amounts of them. By and large, however, they are a long-term hold, where no immediate access to underlying liquidity is required. Through so-called collateral upgrade transactions, pension schemes can lend their gilts to a bank, which will, for its part, pledge illiquid assets of equal value to the pension fund, thus removing them from its balance sheet. The bank can now borrow against the gilts in the open market. The returns from the illiquid assets are paid to the bank, and gilt coupons are paid to the pension fund. For safety's sake, a much greater quantity of the illiquid assets will be pledged by the bank in exchange for the pension fund's gilts. The bank pays a fee to the pension fund for the use of its gilts and crucially, if the value of the collateral falls, more is provided. There is also typically an ongoing guarantee. Schemes need to go into such transactions with their eyes wide open. The obvious risk to the pension scheme is that the bank defaults and its assets are insufficient to cover the loss. But the safety improvements in these transactions are designed to offer investors a sufficient level of security.