Gauging the cost of regulatory reform

As US lawmakers battle over the last leg of financial regulatory reform, many worry that the proposals aimed at governing derivatives could generate problems in the future. These fears range from worries over higher capital costs to a drain on bank and corporate earnings. There is also a concern over greater risk exposure as fewer companies decide to hedge.

Banks face higher costs and the prospect of lower earnings across the gamut, whether from the Volcker Rule ban on proprietary trading, hedge fund and private-equity investing for depository institutions; the move to force banks to transfer swap dealing to a separately capitalised subsidiary under section 716 of the proposed law; or the push for more transparency with central clearing houses and trading exchanges. In each instance, banks are expected to lose money and end-users are expected to share in those costs.

"If derivatives capacity is restricted, you're going to see fixed-income and equity investor choices from US broker-dealers decline," warns Betsy Graseck, financial analyst with Morgan Stanley in New York. "End-users are going to have less product choice and liquidity. US banks are going to be unable to offer product efficiently and credit availability will decline because lenders can't hedge their risk." As banks become less flexible, she adds, the cost of financing will go up and volatility will shift back to borrowers.

"Bottom line, the banking system is the intermediary between monetary policy and the real economy. If you reduce the ability to take and manage risk, you're constricting credit," says Ms Graseck.

She estimates that proprietary trading contributes 10% to overall trading revenues, and that 'money centre' banks, including Bank of America, Citigroup and JPMorgan, could experience a 3% hit to their 2012 earnings per share if proprietary trading is killed off. Overall, she expects derivative reform measures to carve 6% from 2012 earnings per share.

Analysts at JPMorgan, meanwhile, predict that affected banks could experience capital shortfalls of $5bn to $26bn if they have to increase minimum capital requirements for their investment banking business to maintain credit ratings under section 716. This part of legislation would force banks to move dealing and trading derivatives to separately capitalised affiliates and would exclude the business from access to Federal Reserve lending facilities or Federal Deposit Insurance Corporation guarantees. If this becomes law, the consequences would extend well beyond these estimated capital costs.

Sharing the cost

As banks struggle to assess the regulatory fallout for their derivatives business, some suggest the cost of hedging could shift more to end-users. "If the derivatives business is separated from banking by law, then there is a larger cost involved for swap dealing associated with capitalising a separate entity," says Brian Yelvington, director of fixed-income research at Knight Capital, an institutional fixed-income broker-dealer in Connecticut.

"Currently an entity might elect to do swaps business with JPMorgan owing to its credit rating. But if JPMorgan has to ring-fence enough capital to maintain that credit rating within a swap dealing entity, it diminishes the capital of the bank. So it could elect to capitalise to a lesser level and put more of the cost of hedging on the books of the hedger."

Higher costs and lower returns on equity could end up making banks "less attractive organisations", says John Colon, a consultant and managing director in the financial services group at Greenwich Associates. "This starts to push them in the direction of being a utility. That's not what the financial industry has been - which is a dynamic industry."

Others worry that legislative language does not address what happens to existing derivatives contracts if banks are forced to ring-fence their derivatives business and transfer contracts to other counterparties. "Novating existing contracts could be a problem," says one bank industry executive.

"There's no mention in legislative language right now about a gradual process. If someone such as DuPont has 1000 contracts with JPMorgan and they're all priced based on JPMorgan's credit risk, does DuPont have to immediately close out existing contracts and replace them with a new counterparty? How does that impact the cost of the contract for end-users? All of this is unclear," the executive says.

Carl Wilkerson, chief counsel, securities and litigation for the American Council of Life Insurers

Perils of standardisation

While it is still unclear if section 716 will survive the final round of legislative negotiations in US Congress, it is all but certain that central clearing houses will become mandatory. Some advocates say this will improve liquidity and transparency by forcing all cleared derivatives contracts to become standardised, but at least one major group of clients worries that this practice could kill their ability to hedge risk: namely, the life insurance companies.

"Part of the uniqueness of the industry is that it has liabilities for 30, 40 and 50 years. So it is critically important that life insurers manage that duration exposure through derivatives," says Carl Wilkerson, chief counsel, securities and litigation for the American Council of Life Insurers.

The industry group is hoping life insurers will be treated as commercial end-users, which are exempt from clearing if swaps are used to hedge commercial risk. As things stand, insurance companies would be forced to go through clearing houses.

Mr Wilkerson worries that centralised clearing of life insurers' non-standardised derivatives transactions "would interfere with responsible risk management because these transactions do not lend themselves to centralised clearing, and most clearing facilities would lack the depth and liquidity to facilitate these transactions and cross-net margin".

He says that unlike a central clearing house, the big five investment banks have the depth to handle the insurance industry's non-standardised over-the-counter (OTC) transactions most efficiently, "while also ensuring reduction in risk through collateralisation, daily margin adjustments, and transparent reporting of transactions to regulators".

One size fits all

It is also unclear what will happen to derivatives contracts that are not liquid enough to qualify for standardisation on central clearing houses. An estimated 50% or more of the overall derivatives market is considered liquid enough to qualify for clearing houses, although liquidity benchmarks have yet to be determined. But for the other half of the US derivatives market that will not qualify, customised contracts could become prohibitively expensive to execute.

"Bespoke contracts could cost multiples of what it would cost to standardise, depending on the capital differential that regulators will require between standardised and bespoke contracts," says Robert Litan, vice-president for research and policy at the Ewing Marion Kauffman Foundation, which promotes entrepreneurship skills. But more contentiously, he suggests that these higher costs could be a good thing for the market.

"Some customers will not want to pay extra fees for customised contracts and will go to standardised contracts that will be cheaper. That is a good thing for the system. The more contracts that go that route, the safer the system will be. And if some do not want to engage, my reaction is tough - we need higher capital to stand behind bespoke derivatives," says Mr Litan.

Karen Petrou, co-founder of consultancy Federal Financial Analytics in Washington, DC, believes that standardisation through clearing houses and exchanges will actually bring down the cost of hedging through derivatives and believes a larger portion of the market can be standardised than some suggest. "I think this is very simple. Just because I bought a dress in size six and you bought the same dress in size eight, does not mean it is not the same dress. In the OTC market, there's a tremendous amount of profit based on individual contracts. They may be standard, but pricing does not reflect that."

Pricing could reflect these changes soon enough, as derivatives are re-routed through clearing houses and trades are executed through swap execution facilities (SEFs), if this mandate is passed. The creation of SEFs is aimed at promoting electronic trading in OTC derivatives markets. In an April report, JPMorgan analyst Kian Abouhossein warned: "We estimate that bid/ask spreads for OTC derivatives could decline significantly when trades are executed on SEFs." He estimates that post-trade transparency requirement for all OTC derivatives would reduce margins by about 25% for "impacted (low-transparency) products, with no corresponding volume offset".

Some contend less profit and higher capital costs are an inevitable part of the evolution for the derivatives market - much like the change the US corporate bond market was forced to undergo when it was held to a higher standard of transparency in 2002. That is when the Trade Reporting and Compliance Engine (Trace) was introduced to report and disseminate price and transaction data for US corporate debt securities.

That said, the changes facing the derivatives market are far more encompassing than what the US corporate bond market faced several years ago, when Trace was introduced. While few can argue that more transparency is essential for reducing future systemic risk in the derivatives market, it remains unclear if the current push for safety will mean a crop of new risks in the future.