A 'small' modification to the standardised method for measuring over-the-counter derivatives exposures threatens yet another layer of costs for banks.
What's happening?
The torrent of regulation designed to make it safer to trade and hold derivatives shows no sign of stopping, even as some over-the-counter (OTC) products apparently face extinction for being too expensive to use due to higher capital requirements.
Indeed, the topic of derivatives was once again aired in April by the Basel Committee on Banking Supervision (BCBS) in a consultation called 'Revisions to the Basel III leverage ratio framework'.
In terms of derivatives, the BCBS wants to replace the current exposure method (CEM) to measure replacement cost and potential future exposure (PFE) for derivatives with a standardised approach for measuring counterparty credit risk exposures (SA-CCR). PFE is a way of accounting for possible future impacts over the lifetime of a trade, such as sharp moves in underlying market prices.
Why is it happening?
The BCBS identified several deficiencies with CEM, which prompted it to develop its SA-CCR approach. These include the fact that CEM does not differentiate between margined and un-margined transactions, and did a poor job of capturing the type of volatility seen during periods of stress, despite various tweaks to make it more robust.
Another BCBS criticism is that the recognition of netting was too simplistic and failed to properly reflect economically meaningful relationships between derivative positions.
What do the banks say?
CEM, as the BCBS itself points out, tends to be relatively conservative when it comes to measuring exposure. The part that sends the mercury spiralling upwards for large banks is that the BCBS wants to introduce a modified SA-CCR approach. Put simply, the BCBS wants collateral or initial margin deposited by bank clients to be ignored for determining the PFE for centrally cleared derivatives trades.
This ties in with one of the fundamental principles of the Basel III leverage ratio framework: “Banks must not take account of physical or financial collateral, guarantees or other credit risk mitigation techniques to reduce the leverage ratio exposure measure.”
In other words, there is less scope for capital efficiency.
However, the BCBS believes that the shorter timeframe for cleared margined derivatives trades should compensate for the initial margin issue. Also, in certain circumstances, and provided a bank is not giving performance guarantees to a clearer, the BCBS proposes exempting the bank’s trade exposures for the purpose of the leverage ratio.
Respondents have until July 6 to give their feedback on the consultation, and the BCBS has indicated that it is open to alternative arguments backed with data.
WILL IT PROVIDE THE INCENTIVES?
The BCBS is trying to support the use of centrally cleared derivatives trades while ensuring bank balance sheets are not threatened by, say, extreme market volatility. The problem is that it could make the use of OTC derivatives – even cleared ones – more expensive, particularly when all the other capital-hungry measures are piled on.
The costs might make corporates reconsider some of their hedging strategies. Arguably, it is not a good idea to render some types of insurance so expensive for corporates that they end up leaving themselves exposed to risk, which they are able to manage less well than a global bank with its extensive risk mitigation capabilities.
However, it might drive further innovation as banks strive harder to squeeze out efficiencies wherever they can find them to compensate for the heavier regulatory burden. One increasingly popular method is trade compression, which involves netting out opposing trades, which in turn lowers the use of capital as, for example, two trades with opposite exposures are compressed down to one.
The technique has for years been used for simple cleared trades and others that were easy to reconcile. Doing the same for more complex derivatives products is a lot more demanding and has been an area of focus for banks over the past few years.
It is already having some impact. The Bank for International Settlements’ (BIS) latest data identifies trade compression as one of the main reasons behind the shrinkage in the OTC derivatives market, rather than certain products being culled by tougher rules.
According to the BIS, this market’s gross value shrank by 6% in the six months to the end of December 2015 to $14,500bn, the lowest level since 2007. Interest rate swaps account for most of that decline. Given the growing amount of regulation aimed at derivatives, such as this latest salvo from the BCBS, that trend is likely to continue for several more years yet.
