Basel III Endgame and G-SIB Surcharge may reduce clearing access for SFT and derivatives markets
09 February 2024 US
Image: AdobeStock/bakhtiarzein
Two industry associations, the International Swaps and Derivatives Association (ISDA) and the 色花堂Industry and Financial Markets Association (SIFMA), have collaborated to deliver a joint response to the US Basel III Endgame and G-SIB Surcharge consultations.
In this joint submission, submitted on 16 January 2024, they warn that the proposals are likely to lead to a sizeable increase in capital requirements for banks with activities in US markets.
Significantly, they contend that these proposed increases in regulatory capital against banks鈥� trading and clearing activities do not align with the underlying risks associated with these activities. Implementation of the US Basel III 鈥榚ndgame鈥� proposals, they suggest, will make it harder and more costly for banks to provide these services. If banks are forced to reduce their engagement in these areas, this could have a negative impact on liquidity and vibrancy of US capital markets, thereby increasing costs, reducing choice and impairing risk management for market participants and for US businesses more widely.
Commenting on the background to their joint submission, ISDA head of capital Panayiotis Dionysopoulos tells 色花堂Finance Times that the aim was to maximise efficiency and minimise duplication in responding to this consultation process. 鈥淚SDA and SIFMA have both focused on capital markets activity and we have considerable overlap in terms of our membership,鈥� he says. 鈥淐onsequently, it makes sense when responding to major technical proposals, such as the Basel III proposal and the G-SIB surcharge proposals, to collaborate in preparing our responses.鈥�
Quantitative impact survey
To evaluate the potential impact of the proposed rule changes, the two associations conducted a quantitative impact survey (QIS), with responses from eight US global systemically important banking organisations (G-SIBs). This analysis, which provided the foundation for their consultation feedback to the Basel III notice of proposed rulemaking (NPR), indicates that market risk capital would increase by between 73 per cent and 112 per cent, depending on the extent to which banks use internal models. 鈥淭hat is a lot of extra capital, which we think is not justified by the levels of risk,鈥� say the two associations.
Expanding on these conclusions, Dionysopoulos indicates that the impact on market risk has been top of mind for many large banking organisations. Under the US Basel III proposal, banks will need to meet stringent requirements to use internal models for market risk. The 112 per cent upper boundary is calculated for a firm applying the standardised approach to the full portfolio and, by making it more difficult to apply internal risk models, firms are moving closer to that upper boundary.
For credit valuation adjustment (CVA), most banks are currently constrained by the US standardised approach, which includes credit risk and market risk. However, the revised US Basel III proposal will include operational risk and CVA as part of the expanded risk-based approach (ERBA), which will become the new binding constraint for more US G-SIBs 鈥� so the CVA element is fully additive when compared with the current standardised approach.
For clarification, the CVA is an adjustment to the market price of derivatives and securities financing transactions (SFTs) to take into account the default risk of the counterparty.
In the QIS, ISDA and SIFMA modelled more than 40 scenarios to evaluate the potential impact, utilising aggregated and anonymised data supplied by survey respondents. The scenarios cover aspects across market risk, CVA, securities financing transactions and clearing business.
Client clearing
Looking more closely at the derivatives clearing component, the trade associations advise that the proposed changes to bank capital rules may prompt some clearing banks to reduce client clearing activity. As an unintended consequence, this may act as a brake on the efforts of policymakers, since the 2009 G20 recommendations, to encourage wider use of central clearing across a range of transaction types.
The impact will vary from bank to bank, depending on how its business is structured and how it manages clearing of clients鈥� portfolios. However, ISDA鈥檚 head of clearing services Ulrich Karl anticipates that this will create pressure on some clearing firms to reduce their derivatives notional exposures and become more selective about their range of clients. On balance, this is likely to create additional pressure on the clearing capacity of the affected banks 鈥� and, by association, it may make it more difficult for some clients to access clearing for their derivatives transactions and SFTs.
Data from the QIS reveals that adding clients鈥� derivatives notional exposures cleared under the agency model to the complexity indicator added 69.4 G-SIB points, based on data from six G-SIBs. Adding these transactions under the interconnectedness indicators had a smaller impact of 4.5 G-SIB points (see box). Therefore, in total, the proposal is expected to increase the G-SIB score for the six participating banks by 74 points.
To put this in context, 20 G-SIB points adds a further 10 basis points of additional surcharge. While this would result in an increase in the method surcharge of slightly more than 7bps on average per bank, this increase, applied to risk-weighted assets (RWAs) calculated under the proposed ERBA, would result in an additional capital contribution of approximately US$5.2 billion across the six G-SIBs (G-SIB response, p 3).
Prudential regulators may conclude that there is a case for requiring banks to put up additional capital against this client clearing activity. But, for Karl, they should be aware that this may make it more difficult for some buy-side firms to access clearing services and therefore act as a disincentive for clearing. 鈥淢ost market participants agree that central clearing has made markets much safer,鈥� he says. 鈥淔or that reason, we have urged the Federal Reserve to liaise with other market regulators, particularly the 色花堂and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).鈥�
In the case of a clearing member default, the proposed changes may also make it more difficult to 鈥榩ort鈥� client portfolios to a new clearing member. To do so, other clearing members must be able to meet the additional capital requirements to take on clearing activity from new clients. The proposed rule amendments may impair this process by adding to the capital overhead borne by banks against their clearing activity.
鈥淥n balance, we believe these proposed changes would directly contravene the longstanding public policy objective to promote central clearing,鈥� say the two associations.
Capital markets liquidity
To protect the liquidity and vibrancy of the US capital markets, ISDA and SIFMA have recommended that US agencies revise how banking organisations can recognise risk diversification when calculating market risk RWAs under the EBRA, thereby delivering a risk calculation methodology that aligns better with their actual risk exposure and the risk management frameworks they apply. 鈥淕etting the right recognition of diversification in the capital framework is hugely important,鈥� notes Dionysopoulos.
The two associations have also urged the US Federal Reserve to review its plans to implement a framework for minimum haircut floors for SFTs. The minimum haircut floors framework for SFTs was introduced into the Basel standards in 2017, taking into account a recommendation made by the Financial Stability Board (FSB) to introduce numerical haircut floors for non-centrally cleared SFTs in which secured financing is provided to non-banks against collateral other than government debt.
With respect to securities finance transactions, ISDA and SIFMA estimate that the application of the minimum haircut floor would result in a significant increase in bank capital requirements against this activity. Based on the QIS results, the total impact for SFTs would be an 18 per cent increase in capital requirements.
Other jurisdictions outside the US, including Canada, the EU, Japan and the UK, have not implemented minimum haircut floors. With respect to the EU, the European Banking Authority has raised concerns over potential implementation of the minimum haircut floor framework, asking for further discussion on the range of transactions and organisations that fall into scope of this provision and its impact on certain parts of the market, including securities lending and borrowing and the application of netting in cleared transactions.
For ISDA and SIFMA, the overarching conclusion is that implementing the minimum haircut floor framework would lead to competitive disadvantages for banking organisations that are subject to the US capital rules when compared with firms operating in the EU and UK that do not fall into scope of this framework.
鈥淭he capital cost implications for SFT activity are similar to the client clearing business,鈥� observes Dionysopoulos. 鈥淭hese are low margin businesses and, when you start adding more costs, these activities may become uneconomic for some firms providing these services.鈥� This could potentially result in further consolidation across the industry and a reduction in the choice of clearing providers active in this market segment.
For credit valuation adjustment, ISDA and SIFMA are recommending the addition of further granularity in the framework. 鈥淭his is important for the financial risk bucket, where there is currently a single bucket with the same risk weight for regulated and unregulated entities,鈥� says Dionysopoulos. 鈥淭his is not in line with the underlying risk profile of those entities.鈥�
In the UK, for example, the Bank of England has introduced an additional bucket for pension funds in recognition of the different risk profile presented by their businesses.
The overarching question is how US agencies can make this framework more risk sensitive, given that large banks will no longer have the option of applying their own internal models for CVA and will need to apply the standardised approach or the basic approach.
The two associations have also recommended an exemption of the client-facing leg of a cleared derivatives transaction from CVA capital requirements, given that 鈥� in their assessment 鈥� these exposures do not pose any CVA risk (fig 2). They estimate that the removal of the CVA charge for client cleared transactions can mitigate capital requirements for the clearing business by US$1 billion.
Implementation timeline
The two associations have recommended that the implementation deadline should be extended from the 1 July 2025 implementation date currently proposed to be at least 18 months from the finalisation of the rule.
鈥淭he time frame will be dependent on when a final set of rules is approved and published,鈥� explains Dionysopoulos. 鈥淏anks cannot finalise their model development or produce the required data for model applications until they have a final rule set to work with.鈥�
Banks will need to put in considerable work to reconfigure their capital modelling and the data inputs required to inform this process. For market risk, banks that plan to apply to use internal models will need to refine their modelling and submit applications for the trading desks in scope. Financial supervisors will then require time to review and approve those applications.
Significantly, standardised approaches under the US Basel III proposals are becoming more demanding 鈥� these need to be calculated more frequently and require a larger set of data points to produce these calculations. This represents a departure from the standardised approaches of the past that were, in relative terms, simpler and more straightforward. Under the new proposals, standardised approaches are more risk sensitive and banks will require time to make the required changes and to attain the necessary approvals.
More broadly, banks must consider the implications of these revisions not just in the US, but across their global businesses. Trading in derivatives and SFTs is global in nature and one of the biggest concerns for member firms is having major regulatory changes going live at different times in different jurisdictions. For global banks operating across a wide range of jurisdictions, these regulatory changes may have a major impact on how they manage their trading books in different locations.
The consequence for the real economy, the associations argue, is that commercial end-users 鈥� and other derivatives end-users 鈥� will find that the cost for derivatives may increase or some products will become less readily available. Considered together, there is a danger that the combination of increased CVA, market risk and operational risk capital requirements will significantly impair the ability of corporates, insurance companies and pension funds to hedge their business risks.
In this joint submission, submitted on 16 January 2024, they warn that the proposals are likely to lead to a sizeable increase in capital requirements for banks with activities in US markets.
Significantly, they contend that these proposed increases in regulatory capital against banks鈥� trading and clearing activities do not align with the underlying risks associated with these activities. Implementation of the US Basel III 鈥榚ndgame鈥� proposals, they suggest, will make it harder and more costly for banks to provide these services. If banks are forced to reduce their engagement in these areas, this could have a negative impact on liquidity and vibrancy of US capital markets, thereby increasing costs, reducing choice and impairing risk management for market participants and for US businesses more widely.
Commenting on the background to their joint submission, ISDA head of capital Panayiotis Dionysopoulos tells 色花堂Finance Times that the aim was to maximise efficiency and minimise duplication in responding to this consultation process. 鈥淚SDA and SIFMA have both focused on capital markets activity and we have considerable overlap in terms of our membership,鈥� he says. 鈥淐onsequently, it makes sense when responding to major technical proposals, such as the Basel III proposal and the G-SIB surcharge proposals, to collaborate in preparing our responses.鈥�
Quantitative impact survey
To evaluate the potential impact of the proposed rule changes, the two associations conducted a quantitative impact survey (QIS), with responses from eight US global systemically important banking organisations (G-SIBs). This analysis, which provided the foundation for their consultation feedback to the Basel III notice of proposed rulemaking (NPR), indicates that market risk capital would increase by between 73 per cent and 112 per cent, depending on the extent to which banks use internal models. 鈥淭hat is a lot of extra capital, which we think is not justified by the levels of risk,鈥� say the two associations.
Expanding on these conclusions, Dionysopoulos indicates that the impact on market risk has been top of mind for many large banking organisations. Under the US Basel III proposal, banks will need to meet stringent requirements to use internal models for market risk. The 112 per cent upper boundary is calculated for a firm applying the standardised approach to the full portfolio and, by making it more difficult to apply internal risk models, firms are moving closer to that upper boundary.
For credit valuation adjustment (CVA), most banks are currently constrained by the US standardised approach, which includes credit risk and market risk. However, the revised US Basel III proposal will include operational risk and CVA as part of the expanded risk-based approach (ERBA), which will become the new binding constraint for more US G-SIBs 鈥� so the CVA element is fully additive when compared with the current standardised approach.
For clarification, the CVA is an adjustment to the market price of derivatives and securities financing transactions (SFTs) to take into account the default risk of the counterparty.
In the QIS, ISDA and SIFMA modelled more than 40 scenarios to evaluate the potential impact, utilising aggregated and anonymised data supplied by survey respondents. The scenarios cover aspects across market risk, CVA, securities financing transactions and clearing business.
Client clearing
Looking more closely at the derivatives clearing component, the trade associations advise that the proposed changes to bank capital rules may prompt some clearing banks to reduce client clearing activity. As an unintended consequence, this may act as a brake on the efforts of policymakers, since the 2009 G20 recommendations, to encourage wider use of central clearing across a range of transaction types.
The impact will vary from bank to bank, depending on how its business is structured and how it manages clearing of clients鈥� portfolios. However, ISDA鈥檚 head of clearing services Ulrich Karl anticipates that this will create pressure on some clearing firms to reduce their derivatives notional exposures and become more selective about their range of clients. On balance, this is likely to create additional pressure on the clearing capacity of the affected banks 鈥� and, by association, it may make it more difficult for some clients to access clearing for their derivatives transactions and SFTs.
Data from the QIS reveals that adding clients鈥� derivatives notional exposures cleared under the agency model to the complexity indicator added 69.4 G-SIB points, based on data from six G-SIBs. Adding these transactions under the interconnectedness indicators had a smaller impact of 4.5 G-SIB points (see box). Therefore, in total, the proposal is expected to increase the G-SIB score for the six participating banks by 74 points.
To put this in context, 20 G-SIB points adds a further 10 basis points of additional surcharge. While this would result in an increase in the method surcharge of slightly more than 7bps on average per bank, this increase, applied to risk-weighted assets (RWAs) calculated under the proposed ERBA, would result in an additional capital contribution of approximately US$5.2 billion across the six G-SIBs (G-SIB response, p 3).
Prudential regulators may conclude that there is a case for requiring banks to put up additional capital against this client clearing activity. But, for Karl, they should be aware that this may make it more difficult for some buy-side firms to access clearing services and therefore act as a disincentive for clearing. 鈥淢ost market participants agree that central clearing has made markets much safer,鈥� he says. 鈥淔or that reason, we have urged the Federal Reserve to liaise with other market regulators, particularly the 色花堂and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).鈥�
In the case of a clearing member default, the proposed changes may also make it more difficult to 鈥榩ort鈥� client portfolios to a new clearing member. To do so, other clearing members must be able to meet the additional capital requirements to take on clearing activity from new clients. The proposed rule amendments may impair this process by adding to the capital overhead borne by banks against their clearing activity.
鈥淥n balance, we believe these proposed changes would directly contravene the longstanding public policy objective to promote central clearing,鈥� say the two associations.
Capital markets liquidity
To protect the liquidity and vibrancy of the US capital markets, ISDA and SIFMA have recommended that US agencies revise how banking organisations can recognise risk diversification when calculating market risk RWAs under the EBRA, thereby delivering a risk calculation methodology that aligns better with their actual risk exposure and the risk management frameworks they apply. 鈥淕etting the right recognition of diversification in the capital framework is hugely important,鈥� notes Dionysopoulos.
The two associations have also urged the US Federal Reserve to review its plans to implement a framework for minimum haircut floors for SFTs. The minimum haircut floors framework for SFTs was introduced into the Basel standards in 2017, taking into account a recommendation made by the Financial Stability Board (FSB) to introduce numerical haircut floors for non-centrally cleared SFTs in which secured financing is provided to non-banks against collateral other than government debt.
With respect to securities finance transactions, ISDA and SIFMA estimate that the application of the minimum haircut floor would result in a significant increase in bank capital requirements against this activity. Based on the QIS results, the total impact for SFTs would be an 18 per cent increase in capital requirements.
Other jurisdictions outside the US, including Canada, the EU, Japan and the UK, have not implemented minimum haircut floors. With respect to the EU, the European Banking Authority has raised concerns over potential implementation of the minimum haircut floor framework, asking for further discussion on the range of transactions and organisations that fall into scope of this provision and its impact on certain parts of the market, including securities lending and borrowing and the application of netting in cleared transactions.
For ISDA and SIFMA, the overarching conclusion is that implementing the minimum haircut floor framework would lead to competitive disadvantages for banking organisations that are subject to the US capital rules when compared with firms operating in the EU and UK that do not fall into scope of this framework.
鈥淭he capital cost implications for SFT activity are similar to the client clearing business,鈥� observes Dionysopoulos. 鈥淭hese are low margin businesses and, when you start adding more costs, these activities may become uneconomic for some firms providing these services.鈥� This could potentially result in further consolidation across the industry and a reduction in the choice of clearing providers active in this market segment.
For credit valuation adjustment, ISDA and SIFMA are recommending the addition of further granularity in the framework. 鈥淭his is important for the financial risk bucket, where there is currently a single bucket with the same risk weight for regulated and unregulated entities,鈥� says Dionysopoulos. 鈥淭his is not in line with the underlying risk profile of those entities.鈥�
In the UK, for example, the Bank of England has introduced an additional bucket for pension funds in recognition of the different risk profile presented by their businesses.
The overarching question is how US agencies can make this framework more risk sensitive, given that large banks will no longer have the option of applying their own internal models for CVA and will need to apply the standardised approach or the basic approach.
The two associations have also recommended an exemption of the client-facing leg of a cleared derivatives transaction from CVA capital requirements, given that 鈥� in their assessment 鈥� these exposures do not pose any CVA risk (fig 2). They estimate that the removal of the CVA charge for client cleared transactions can mitigate capital requirements for the clearing business by US$1 billion.
Implementation timeline
The two associations have recommended that the implementation deadline should be extended from the 1 July 2025 implementation date currently proposed to be at least 18 months from the finalisation of the rule.
鈥淭he time frame will be dependent on when a final set of rules is approved and published,鈥� explains Dionysopoulos. 鈥淏anks cannot finalise their model development or produce the required data for model applications until they have a final rule set to work with.鈥�
Banks will need to put in considerable work to reconfigure their capital modelling and the data inputs required to inform this process. For market risk, banks that plan to apply to use internal models will need to refine their modelling and submit applications for the trading desks in scope. Financial supervisors will then require time to review and approve those applications.
Significantly, standardised approaches under the US Basel III proposals are becoming more demanding 鈥� these need to be calculated more frequently and require a larger set of data points to produce these calculations. This represents a departure from the standardised approaches of the past that were, in relative terms, simpler and more straightforward. Under the new proposals, standardised approaches are more risk sensitive and banks will require time to make the required changes and to attain the necessary approvals.
More broadly, banks must consider the implications of these revisions not just in the US, but across their global businesses. Trading in derivatives and SFTs is global in nature and one of the biggest concerns for member firms is having major regulatory changes going live at different times in different jurisdictions. For global banks operating across a wide range of jurisdictions, these regulatory changes may have a major impact on how they manage their trading books in different locations.
The consequence for the real economy, the associations argue, is that commercial end-users 鈥� and other derivatives end-users 鈥� will find that the cost for derivatives may increase or some products will become less readily available. Considered together, there is a danger that the combination of increased CVA, market risk and operational risk capital requirements will significantly impair the ability of corporates, insurance companies and pension funds to hedge their business risks.
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