Under pressure: financial services turns the screw
05 July 2016
The BCBS has been taken to task over its latest leverage ratio framework proposal, with commentators claiming it may unbalance global markets and damage the business model of clearinghouses
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The latest iteration of the Basel Committee on Banking Supervision鈥檚 (BCBS) Basel III leverage ratio framework has galvanised the global financial services industry into action to ensure that the final proposal, which is due by the end of 2016, is a viable addition to the post-financial crisis regulatory framework.
The BCBS presented its new proposal, which already includes several revisions from its original version, in April and offered financial services a final opportunity to provide feedback鈥攁nd the response was damning.
One comment letter, signed by 30 exchanges and clearinghouses, along with other stakeholders, said the leverage ratio, in its current form, fundamentally threatens their business model and could affect financial market stability.
In total, 53 comment letters were sent to the BCBS during the three-month consultation. The full list of industry comment letters is available to read on the Bank for International Settlement鈥檚 website.
The revisions
The revised framework revealed a number of proposals for amendments that may be made to the framework, based on previous issues raised by financial services. These included:
鈥� The use a modified version of the standardised approach for measuring counterparty credit risk exposures (SA-CCR) instead of the current exposure method (CEM) to measure derivative exposures;
鈥� Two options for the treatment of regular-way purchases and sales of financial assets to ensure consistency across accounting standards;
鈥� A clarification on the treatment of provisions and prudential valuation adjustments for less liquid positions to avoid double-counting; and
鈥� An alignment of the credit conversion factors for off-balance sheet items, with those proposed for the standardised approach to credit risk under the risk-based framework
Get your clearinghouse in order
The clearinghouse and exchange-backed letter boasted several signatories, including ABN AMRO Clearing Bank, Eurex Clearing, the Options Clearing Corporation (OCC) and Nasdaq, making it one of the most significant comment letters in the long list of respondents.
Beyond its initial stark warning, the letter鈥檚 signatories positively acknowledged the progress that the framework has already made from its initial form. They reiterated their encouragement that further progress can be made thanks to the BCBS鈥檚 willingness to continue respecting the various concerns of financial services. But they also didn鈥檛 shy away from the fact that significant work is still needed before the final proposal is published.
The letter鈥檚 signatories took particular issue with the CEM, arguing that the SA-CCR offers a better alternative to calculating leverage for exchange-traded derivative (ETD) exposures.
The letter states: 鈥淸With the CEM] the application of the leverage ratio will result in vastly increased capital requirements for general clearing members offering clearing services to market makers and liquidity providers.The leverage ratio does not take the different characteristics and risks of ETD and OTC instruments into account. For ETD, we believe that a different treatment compared to over-the-counter (OTC) derivatives would be warranted recognising the applicable netting rules and CCP clearing processes.鈥�
The letter was also one of many that drew attention to a number of unintended consequences that the current leverage ratio framework threatens to impose.
鈥淲e note that a number of general clearing members (GCMs) have already ceased their operations while others are re-assessing their business models. Data from the US Commodity Futures Trading Commission shows a steady decrease in the number of futures commission merchants, while at the same time the number of total cleared client assets has increased significantly driven by new clearing mandates since 2009.鈥�
鈥淲e fear that a further reduction of GCMs will result in an undesirable lack of choice for end-users and decrease available (global) balance sheet capacity for clearing of derivatives transactions, including those that are anticipated to become subject to mandatory clearing.鈥�
John Fennell, OCC executive vice president of financial risk management, expanded upon the issues it raised, pointing out that options in particular are treated incorrectly.
He said: 鈥淸The leverage ratio] creates the real potential to move liquidity away from the listed and centrally cleared markets and ultimately back to the opaque bilateral OTC markets. This is counter to the global mandate by regulators to bring more OTC volume into centrally cleared solutions mitigating systemic risk.鈥�
鈥淭he issue with the leverage ratio, and specifically the CEM, is that it neglects to recognise the risk limiting effects associated with being long and short options of different strikes on the same underlying instrument. Hedging option risk using other options is the most effective and relied upon way option market makers mitigate the risks assumed as they fulfill their vital role of providing committed liquidity to the cleared markets.鈥�
鈥淥ur desire is that the regulators adopt SA-CCR as quickly as possible, which does not have the same shortcomings of CEM, or provide an exemption for options market makers, given the vital role they fill in providing committed liquidity to these markets.鈥�
Another noteworthy response included the views of five financial industry associations, including the International Swaps and Derivatives Association (ICMA), which joined forces to express their strong concern about the implications of including central bank cash balances within the leverage ratio framework.
The associations noted and echoed the sentiments of the Bank of England鈥檚 Financial Policy Committee, which raised its the same concern with the leverage ratio framework in its review on 5 July.
All five associations reiterated their support for the BCBS鈥檚 broad aims to mitigate market risk and boost transparency, but also highlighted the need to expand the scope of the BCBS鈥檚 review and 鈥渃arefully consider the way cash and unencumbered cash equivalent assets are treated in the leverage ratio鈥�.
They said they share the Financial Policy Committee鈥檚 concerns that including central bank deposits in the leverage ratio could affect the ability of the banking system to cushion shocks.
Kenneth Bentsen, CEO of the Global Financial Markets Association, a trade group that joined ICMA in submitting to the consultation, explained: 鈥淓ven client transactions that are designed to reduce risk will require broker-dealers to expand their balance sheets. Regulations should not impair clients鈥� ability to conduct risk-reducing transactions in cases where these transactions do not add risk to banks鈥� balance sheets.鈥�
鈥淏y excluding cash and cash equivalents from the exposure measure of the leverage ratio, regulators could alleviate the constraints on these important market activities, especially in distressed markets.鈥�
Scott O鈥橫alia, ISDA鈥檚 CEO, added: 鈥淭he leverage ratio as it stands makes the economics of client clearing extremely difficult for clearing members, which runs counter to the objective set by the G20 nations to encourage central clearing.鈥�
鈥淲e welcome the decision by the BCBS to collect data to study the impact of the leverage ratio on client clearing, but we are disappointed it has not taken the opportunity to consult on the recognition of initial margin more widely.鈥�
The associations also noted that the BCBS did not resolve the issue of whether to recognise collateral posted by counterparties on derivatives trades more broadly. Additionally, the lack of recognition of high-quality liquid assets as variation margin will potentially limit the access to derivatives of pension funds and other end users that rely on the ability to post securities collateral.
The associations added in their joint statement: 鈥淭he BCBS should consider how other cash equivalent securities, such as US Treasuries and other high-quality government bonds, are treated in the leverage ratio and the broader Basel framework.鈥�
鈥淭hese securities underpin the soundness of the financial system and are used as collateral by most market participants for central clearing and as liquidity reserves by all banks and other market participants. If banks are bound by the leverage ratio, they cannot provide financing, even against such high-quality assets, and this may significantly reduce risk warehousing capacity on a system-wide level.鈥�
Over the Hill
The leverage ratio also attracted criticism from departing UK representative in the European Commission, Jonathan Hill, who spearheaded financial services reform. Hill resigned following the UK鈥檚 referendum on its EU membership, which kicked off the so-called Brexit, and couldn鈥檛 resist a parting blow in his final speech before the European Parliament on 13 July.
Hill said: 鈥淚n the banking sector, we need to be sure that measures being considered by the Basel Committee鈥攍ike the leverage ratio, the net stable funding ratio, and the fundamental review of the trading book鈥攚ork for Europe.鈥�
鈥淢any people who replied to the call for evidence said they worried about the impact of those measures and how they interacted with existing rules. They are also worried about the impact of future measures on areas like trade finance, market liquidity and on access to clearing services.鈥�
He added: 鈥淭rade finance loans are typically less risky than standard corporate loans. But people have told us that this is not recognised properly by the Basel measures being developed. They worry that neither the leverage ratio nor the NSFR will recognise the specific nature of trade finance.鈥�
鈥淪o we need to look at whether these measures can be adjusted and see whether we can lower the NSFR required stable funding factor and exempt trade financing altogether from the leverage ratio calculation.鈥�
Hill did express confidence that the BCBS would continue to work closely with financial services to ensure the final result is acceptable to all parties. 鈥淭hat [banking reform] is of course no longer up to me. It will now be up to my colleague Valdis Dombrovskis to take it forward with you. I could not be leaving the [leverage ratio鈥檚] call for evidence in better hands,鈥� Hill concluded.
The BCBS presented its new proposal, which already includes several revisions from its original version, in April and offered financial services a final opportunity to provide feedback鈥攁nd the response was damning.
One comment letter, signed by 30 exchanges and clearinghouses, along with other stakeholders, said the leverage ratio, in its current form, fundamentally threatens their business model and could affect financial market stability.
In total, 53 comment letters were sent to the BCBS during the three-month consultation. The full list of industry comment letters is available to read on the Bank for International Settlement鈥檚 website.
The revisions
The revised framework revealed a number of proposals for amendments that may be made to the framework, based on previous issues raised by financial services. These included:
鈥� The use a modified version of the standardised approach for measuring counterparty credit risk exposures (SA-CCR) instead of the current exposure method (CEM) to measure derivative exposures;
鈥� Two options for the treatment of regular-way purchases and sales of financial assets to ensure consistency across accounting standards;
鈥� A clarification on the treatment of provisions and prudential valuation adjustments for less liquid positions to avoid double-counting; and
鈥� An alignment of the credit conversion factors for off-balance sheet items, with those proposed for the standardised approach to credit risk under the risk-based framework
Get your clearinghouse in order
The clearinghouse and exchange-backed letter boasted several signatories, including ABN AMRO Clearing Bank, Eurex Clearing, the Options Clearing Corporation (OCC) and Nasdaq, making it one of the most significant comment letters in the long list of respondents.
Beyond its initial stark warning, the letter鈥檚 signatories positively acknowledged the progress that the framework has already made from its initial form. They reiterated their encouragement that further progress can be made thanks to the BCBS鈥檚 willingness to continue respecting the various concerns of financial services. But they also didn鈥檛 shy away from the fact that significant work is still needed before the final proposal is published.
The letter鈥檚 signatories took particular issue with the CEM, arguing that the SA-CCR offers a better alternative to calculating leverage for exchange-traded derivative (ETD) exposures.
The letter states: 鈥淸With the CEM] the application of the leverage ratio will result in vastly increased capital requirements for general clearing members offering clearing services to market makers and liquidity providers.The leverage ratio does not take the different characteristics and risks of ETD and OTC instruments into account. For ETD, we believe that a different treatment compared to over-the-counter (OTC) derivatives would be warranted recognising the applicable netting rules and CCP clearing processes.鈥�
The letter was also one of many that drew attention to a number of unintended consequences that the current leverage ratio framework threatens to impose.
鈥淲e note that a number of general clearing members (GCMs) have already ceased their operations while others are re-assessing their business models. Data from the US Commodity Futures Trading Commission shows a steady decrease in the number of futures commission merchants, while at the same time the number of total cleared client assets has increased significantly driven by new clearing mandates since 2009.鈥�
鈥淲e fear that a further reduction of GCMs will result in an undesirable lack of choice for end-users and decrease available (global) balance sheet capacity for clearing of derivatives transactions, including those that are anticipated to become subject to mandatory clearing.鈥�
John Fennell, OCC executive vice president of financial risk management, expanded upon the issues it raised, pointing out that options in particular are treated incorrectly.
He said: 鈥淸The leverage ratio] creates the real potential to move liquidity away from the listed and centrally cleared markets and ultimately back to the opaque bilateral OTC markets. This is counter to the global mandate by regulators to bring more OTC volume into centrally cleared solutions mitigating systemic risk.鈥�
鈥淭he issue with the leverage ratio, and specifically the CEM, is that it neglects to recognise the risk limiting effects associated with being long and short options of different strikes on the same underlying instrument. Hedging option risk using other options is the most effective and relied upon way option market makers mitigate the risks assumed as they fulfill their vital role of providing committed liquidity to the cleared markets.鈥�
鈥淥ur desire is that the regulators adopt SA-CCR as quickly as possible, which does not have the same shortcomings of CEM, or provide an exemption for options market makers, given the vital role they fill in providing committed liquidity to these markets.鈥�
Another noteworthy response included the views of five financial industry associations, including the International Swaps and Derivatives Association (ICMA), which joined forces to express their strong concern about the implications of including central bank cash balances within the leverage ratio framework.
The associations noted and echoed the sentiments of the Bank of England鈥檚 Financial Policy Committee, which raised its the same concern with the leverage ratio framework in its review on 5 July.
All five associations reiterated their support for the BCBS鈥檚 broad aims to mitigate market risk and boost transparency, but also highlighted the need to expand the scope of the BCBS鈥檚 review and 鈥渃arefully consider the way cash and unencumbered cash equivalent assets are treated in the leverage ratio鈥�.
They said they share the Financial Policy Committee鈥檚 concerns that including central bank deposits in the leverage ratio could affect the ability of the banking system to cushion shocks.
Kenneth Bentsen, CEO of the Global Financial Markets Association, a trade group that joined ICMA in submitting to the consultation, explained: 鈥淓ven client transactions that are designed to reduce risk will require broker-dealers to expand their balance sheets. Regulations should not impair clients鈥� ability to conduct risk-reducing transactions in cases where these transactions do not add risk to banks鈥� balance sheets.鈥�
鈥淏y excluding cash and cash equivalents from the exposure measure of the leverage ratio, regulators could alleviate the constraints on these important market activities, especially in distressed markets.鈥�
Scott O鈥橫alia, ISDA鈥檚 CEO, added: 鈥淭he leverage ratio as it stands makes the economics of client clearing extremely difficult for clearing members, which runs counter to the objective set by the G20 nations to encourage central clearing.鈥�
鈥淲e welcome the decision by the BCBS to collect data to study the impact of the leverage ratio on client clearing, but we are disappointed it has not taken the opportunity to consult on the recognition of initial margin more widely.鈥�
The associations also noted that the BCBS did not resolve the issue of whether to recognise collateral posted by counterparties on derivatives trades more broadly. Additionally, the lack of recognition of high-quality liquid assets as variation margin will potentially limit the access to derivatives of pension funds and other end users that rely on the ability to post securities collateral.
The associations added in their joint statement: 鈥淭he BCBS should consider how other cash equivalent securities, such as US Treasuries and other high-quality government bonds, are treated in the leverage ratio and the broader Basel framework.鈥�
鈥淭hese securities underpin the soundness of the financial system and are used as collateral by most market participants for central clearing and as liquidity reserves by all banks and other market participants. If banks are bound by the leverage ratio, they cannot provide financing, even against such high-quality assets, and this may significantly reduce risk warehousing capacity on a system-wide level.鈥�
Over the Hill
The leverage ratio also attracted criticism from departing UK representative in the European Commission, Jonathan Hill, who spearheaded financial services reform. Hill resigned following the UK鈥檚 referendum on its EU membership, which kicked off the so-called Brexit, and couldn鈥檛 resist a parting blow in his final speech before the European Parliament on 13 July.
Hill said: 鈥淚n the banking sector, we need to be sure that measures being considered by the Basel Committee鈥攍ike the leverage ratio, the net stable funding ratio, and the fundamental review of the trading book鈥攚ork for Europe.鈥�
鈥淢any people who replied to the call for evidence said they worried about the impact of those measures and how they interacted with existing rules. They are also worried about the impact of future measures on areas like trade finance, market liquidity and on access to clearing services.鈥�
He added: 鈥淭rade finance loans are typically less risky than standard corporate loans. But people have told us that this is not recognised properly by the Basel measures being developed. They worry that neither the leverage ratio nor the NSFR will recognise the specific nature of trade finance.鈥�
鈥淪o we need to look at whether these measures can be adjusted and see whether we can lower the NSFR required stable funding factor and exempt trade financing altogether from the leverage ratio calculation.鈥�
Hill did express confidence that the BCBS would continue to work closely with financial services to ensure the final result is acceptable to all parties. 鈥淭hat [banking reform] is of course no longer up to me. It will now be up to my colleague Valdis Dombrovskis to take it forward with you. I could not be leaving the [leverage ratio鈥檚] call for evidence in better hands,鈥� Hill concluded.
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