Devil in the Basel III details
Securities lending has been hit by a slew of regulations since the crisis, although much of the detail has yet to been finalised. Banks say that some of the legislation is absurdly stringent, with crucial details yet to be hammered out. Some are examining business profitability and the cost of compliance – with capital and liquidity regulations becoming increasingly challenging – and wonder how hard pressed they will be to turn a profit in securities lending.
A series of meetings has been taking place among regulators to try to forge some agreement on the remaining socalled shadow banking initiatives ahead of the November G20 meeting in Australia.
The regulators are mulling the regulatory framework for haircuts on non-centrally cleared securities financing transactions, which will consist of a set of standards used by all market participants, plus an additional framework of numerical haircut floors that will apply to non-centrally cleared securities finance transactions in which firms that are not subject to capital and maturity transformation regulations receive financing from regulated intermediaries against collateral other than government securities.
The Financial Stability Board (FSB) believes a minimum haircut would temper pro-cyclical fluctuations in securities financing, but trade bodies have warned that the minimum haircut methodology and numerical haircut floors are unduly restrictive, and would be a particular blow for prime brokers which calculate haircuts on a portfolio basis rather than on each trade.
Last minute attempts are also being made to amend Basel III’s net stable funding requirements (NSFR), one of its three key capital requirement measures alongside the liquidity coverage ratio (LCR) and the leverage ratio.
The NSFR framework, already revised in January, is designed to ensure that banks maintain a stable funding profile in relation to both their on and off balance sheet activities, in a system that roughly matches their longer-term assets and liabilities, and which will escalate the costs for banks involved in short selling.
The Institute of International Finance and the Global Financial Markets Association have warned that the proposals to the NSFR framework could prompt wider bid-offer spreads, arguing the treatment of equities could potentially force such activities into the largely unregulated shadow banking system, which is counterproductive to the thrust of the regulations.
In a letter sent last week to the Basel Committee on Banking Supervision, the organisations pointed out the need to avoid unnecessary disruptions to “healthy and vibrant equity markets” and to ensure continuing access to bank services.
“Such balancing can be achieved without significant compromise of the committee’s prudential goals because many of the activities in question do not entail shortterm funding of longer-term exposures,” the letter says.
In particular, the institute suggests that stock borrow transactions should be assigned a 0% required stable funding (RSF) factor rather than classify such stock borrows as loans. Second, it advocates that the revised NSFR should recognise a limited class of linked transactions, defined by strict criteria, in which the RSF factor is deemed to equal the available stable funding factor in the light of the low funding and liquidity risks of these transactions and their significant role in equity markets and the larger economy.
Leverage ratio
Alongside NSFR, a second Basel III initiative, the leverage ratio, always captures securities lending transactions. It is well established in the US, but it is now being adopted by the rest of the world and being strengthened in its birthplace. In early September, the Federal Reserve and the other US banking agencies approved a final rule that modifies the denominator calculation of the sup-plementary leverage ratio in a manner consistent with the changes agreed earlier this year by the Basel Committee on Banking Supervision.
The sting for US players is that the largest among them will face a more penal supplementary leverage ratio, effective from January 2018. It requires US global systemically important banks (GSIBs)to maintain a tier-1 capital buffer of at least 2% above the minimum Basel III supplementary leverage ratio of 3%, for a total of 5%, to avoid restrictions on capital distributions and discretionary bonus payments.
The Federal Reserve is also working with global regulators, under the auspices of the FSB, to develop a proposal that would require the largest, most complex global banking firms to maintain a minimum amount of loss absorbency capacity beyond the levels mandated in the Basel III capital requirements, as further measures for the largest organisations remain very much in its sights.
The regulators believe these modifications to the supplementary leverage ratio will result in a more appropriately calibrated measured set of leverage capital requirements and, in aggregate, are expected to modestly increase the stringency of these requirements across the covered banking organisations, according to Daniel Tarullo, a member of the board of governors of the Federal Reserve System.
Tarullo adds that this complements the agencies’ adoption in April of a measure to strengthen the internationally agreedupon Basel III leverage ratio as applied to US-based GSIBs. Key upcoming regulatory and supervisory priorities at the Federal Reserve are to address are the problems of “too big to fail” and systemic risk, he added.
Liquidity coverage ratio
The third Basel III capital plank, the liquidity coverage ratio, is designed to track the amount of liquidity a bank has available to meet its funding needs in a 30-day period. This requirement must be met with highly liquid-rated assets, such as gilts and treasuries, that can easily be converted into cash, ramping up the cost of collateral sourcing for the sell side.
However, the 30-day cut-off is creating a structural problem in securities lending as the needs of lenders and borrowers are pulling in opposite directions. Banks must hold these high-quality liquid assets (HQLS) assets for at least 30 days to avoid hefty charges, while borrowers cannot fund an asset class for less than 31 days without it being capitally prohibitive.
Furthermore, lenders will be reluctant to give up their right to recall their loaned stocks at any time. While borrowers typically look for term borrowing against lower quality collateral at low fees, lenders will want to lend for shorter periods, against higher quality collateral and for higher fees. The regulations make it almost impossible to fund for a short-duration period, driving banks and broker-dealers to term lending, but not fast enough to satisfy the liquidity coverage ratio.
Collateral transformation trades will become more prevalent as participants look to upgrade sub-standard assets to reach their LCR thresholds, as well as satisfying other collateral requirements.
Rob Ferguson, senior vice-president, capital markets and product delivery, at CIBC Mellon, says: “Securities lending market participants continue to see change driven by Basel III, Dodd-Frank and other major global cross-border instruments as well as from various domestic regulatory and industry initiatives.
“A great deal of work is being done by industry stakeholders to account for and prepare for the requirements outlined in these regulations. For example, new and emerging limits and requirements around capitalisation, collateralisation and counterparty concentration mean that many participants will need to carefully consider their securities lending programmes to assess risks as well as take advantage of new opportunities.
“At the end of the day, a successful securities lending programme is dependent upon the ability of the interested parties – beneficial owner, borrower and agent lender – to work within regulatory and business bounds to identify a risk-return balance that is right for all involved. When regulatory changes shift the ground – for example, by implementing rules that drive up demand for certain types of collateral – participants may need to adjust fees, adapt on collateral acceptability and make lending decisions in the broader context of an organisation’s own liquidity and balance sheet requirements.”
The penalty framework around settlement is also causing problems, particularly the lack of clarity around the imposition of mandatory buy-ins after four days, with the industry calling for Esma to delay the mid-2015 deadline and consider the two tier market that would ensue.
“Prospective movement toward central counterparty settlement is another example,” adds Ferguson. “A move to central counterparties (CCPs) would require participants to re-evaluate risk-return equations to account for additional costs associated with CCP settlement as well as the inability to assess each individual counterparty in a given trade.
“Securities lending programmes will remain an important source of riskadjusted return for many beneficial owners, a key tool for many investment managers and an enabler of healthier liquidity. Achieving securities lending success in tomorrow’s regulatory and market environment will require all participants to clearly understand the expectations and impacts of regulation not only on their own businesses but on those of their fellow stakeholders.”
Once fully implemented, the Basel III framework will improve banks’ resilience to asset and liquidity stresses and shocks, but it is too soon to conclude that the industry has achieved stronger creditworthiness, according to ratings agency Moody’s.
The agency has issued a report that notes that banks have made substantial improvements in their fundamentals, including reductions in leverage, the implementation of firm-wide stress testing, and the formation of more robust liquidity and funding profiles.
“Yet,” the report says, “many banks remain challenged in meeting full Basel III requirements while, at the same time, sustaining profitable business models under these more stringent regulatory constraints.” Liquidity in the marketplace has already fallen sharply.
“The regulations reduce the ability of banks to fund client transactions which in turn reduces their ability to finance activities in real business,” says Josh Galper, managing principal of securities-lending consultant Finadium.
“It restricts the real economy in the end. Credit intermediation is risky but necessary to finance the real economy. Whether the regulators will pull back depends on how much the real economy is hindered from growing. This is a big, big deal.”
Indemnification
The Financial Stability Oversight Council (FSOC), a group of regulators that keeps an eye out for emerging risks, believes indemnification agreements – the common practice whereby the agent offers default indemnity to compensate clients if a borrower fails to return a security that some view more valuable than the collateral held by the lender – could be risky for asset managers, which do not face the same capital and liquidity requirements as banks.
A report it issued earlier this month suggests this will be tackled by the FSB’s proposed framework for more intensive supervision of large financial institutions like funds. However, without indemnification, beneficial owners may well shy away from the market, which would also impact market liquidity.
Nervous
Large asset managers are nervous. BlackRock has anticipated the move in a paper sent to regulators that attempts to demonstrate that the firm has sufficient liquidity to meet its indemnification needs. The asset manager also points out that the regulators overstate the risks because the agreements only kick in when a borrower defaults, which is anyway rare, and asset managers then pay only the difference between the value of the security and the collateral.
The annual report of the Treasury Department’s risk council, published in May, also alluded to this but did not name any firms. There will be other major loose ends to tie up after the November summit. The Basel Committee is expected to consult on how to standardise the diversity of ways that lenders use to calculate risks from assets to calculate capital adequacy buffers. This follows scepticism on the part of UK and US regulators over how banks arrive at risk-weighted asset totals.
The proposed measures from the European Commission aimed at increasing thetransparency of transactions in the shadow banking sector, generally referred to as the reporting and transparency of securities financing transactions will require detailed reporting on these operations and that all transactions are reported to a central database.
This is still in the first phase of a European council ministers working group, the beginning of the process, and will take a year to negotiate. The other important feature of this piece of regulation is the requirement to obtain the permission of the lender for any rehypothecation.
“The consequences of the regulation are intended – the amount of focus on securities lending and repo are, I suggest, deliberate,” says Richard Metcalfe, director of regulatory affairs at the IMA.
“Additional reporting and greater transparency is not in itself objectionable but we are concerned that the implementation should be as proportionate as possible. If you look at derivatives reporting which is the main experience we have to go on, the European regulator went further than the US in its requirement on both sides to report. The European policymakers prefer to err on the side of capturing too much information, rather than too little.”
A series of meetings has been taking place among regulators to try to forge some agreement on the remaining socalled shadow banking initiatives ahead of the November G20 meeting in Australia.
The regulators are mulling the regulatory framework for haircuts on non-centrally cleared securities financing transactions, which will consist of a set of standards used by all market participants, plus an additional framework of numerical haircut floors that will apply to non-centrally cleared securities finance transactions in which firms that are not subject to capital and maturity transformation regulations receive financing from regulated intermediaries against collateral other than government securities.
The Financial Stability Board (FSB) believes a minimum haircut would temper pro-cyclical fluctuations in securities financing, but trade bodies have warned that the minimum haircut methodology and numerical haircut floors are unduly restrictive, and would be a particular blow for prime brokers which calculate haircuts on a portfolio basis rather than on each trade.
Last minute attempts are also being made to amend Basel III’s net stable funding requirements (NSFR), one of its three key capital requirement measures alongside the liquidity coverage ratio (LCR) and the leverage ratio.
The NSFR framework, already revised in January, is designed to ensure that banks maintain a stable funding profile in relation to both their on and off balance sheet activities, in a system that roughly matches their longer-term assets and liabilities, and which will escalate the costs for banks involved in short selling.
The Institute of International Finance and the Global Financial Markets Association have warned that the proposals to the NSFR framework could prompt wider bid-offer spreads, arguing the treatment of equities could potentially force such activities into the largely unregulated shadow banking system, which is counterproductive to the thrust of the regulations.
In a letter sent last week to the Basel Committee on Banking Supervision, the organisations pointed out the need to avoid unnecessary disruptions to “healthy and vibrant equity markets” and to ensure continuing access to bank services.
“Such balancing can be achieved without significant compromise of the committee’s prudential goals because many of the activities in question do not entail shortterm funding of longer-term exposures,” the letter says.
In particular, the institute suggests that stock borrow transactions should be assigned a 0% required stable funding (RSF) factor rather than classify such stock borrows as loans. Second, it advocates that the revised NSFR should recognise a limited class of linked transactions, defined by strict criteria, in which the RSF factor is deemed to equal the available stable funding factor in the light of the low funding and liquidity risks of these transactions and their significant role in equity markets and the larger economy.
Leverage ratio
Alongside NSFR, a second Basel III initiative, the leverage ratio, always captures securities lending transactions. It is well established in the US, but it is now being adopted by the rest of the world and being strengthened in its birthplace. In early September, the Federal Reserve and the other US banking agencies approved a final rule that modifies the denominator calculation of the sup-plementary leverage ratio in a manner consistent with the changes agreed earlier this year by the Basel Committee on Banking Supervision.
The sting for US players is that the largest among them will face a more penal supplementary leverage ratio, effective from January 2018. It requires US global systemically important banks (GSIBs)to maintain a tier-1 capital buffer of at least 2% above the minimum Basel III supplementary leverage ratio of 3%, for a total of 5%, to avoid restrictions on capital distributions and discretionary bonus payments.
The Federal Reserve is also working with global regulators, under the auspices of the FSB, to develop a proposal that would require the largest, most complex global banking firms to maintain a minimum amount of loss absorbency capacity beyond the levels mandated in the Basel III capital requirements, as further measures for the largest organisations remain very much in its sights.
The regulators believe these modifications to the supplementary leverage ratio will result in a more appropriately calibrated measured set of leverage capital requirements and, in aggregate, are expected to modestly increase the stringency of these requirements across the covered banking organisations, according to Daniel Tarullo, a member of the board of governors of the Federal Reserve System.
Tarullo adds that this complements the agencies’ adoption in April of a measure to strengthen the internationally agreedupon Basel III leverage ratio as applied to US-based GSIBs. Key upcoming regulatory and supervisory priorities at the Federal Reserve are to address are the problems of “too big to fail” and systemic risk, he added.
Liquidity coverage ratio
The third Basel III capital plank, the liquidity coverage ratio, is designed to track the amount of liquidity a bank has available to meet its funding needs in a 30-day period. This requirement must be met with highly liquid-rated assets, such as gilts and treasuries, that can easily be converted into cash, ramping up the cost of collateral sourcing for the sell side.
However, the 30-day cut-off is creating a structural problem in securities lending as the needs of lenders and borrowers are pulling in opposite directions. Banks must hold these high-quality liquid assets (HQLS) assets for at least 30 days to avoid hefty charges, while borrowers cannot fund an asset class for less than 31 days without it being capitally prohibitive.
Furthermore, lenders will be reluctant to give up their right to recall their loaned stocks at any time. While borrowers typically look for term borrowing against lower quality collateral at low fees, lenders will want to lend for shorter periods, against higher quality collateral and for higher fees. The regulations make it almost impossible to fund for a short-duration period, driving banks and broker-dealers to term lending, but not fast enough to satisfy the liquidity coverage ratio.
Collateral transformation trades will become more prevalent as participants look to upgrade sub-standard assets to reach their LCR thresholds, as well as satisfying other collateral requirements.
Rob Ferguson, senior vice-president, capital markets and product delivery, at CIBC Mellon, says: “Securities lending market participants continue to see change driven by Basel III, Dodd-Frank and other major global cross-border instruments as well as from various domestic regulatory and industry initiatives.
“A great deal of work is being done by industry stakeholders to account for and prepare for the requirements outlined in these regulations. For example, new and emerging limits and requirements around capitalisation, collateralisation and counterparty concentration mean that many participants will need to carefully consider their securities lending programmes to assess risks as well as take advantage of new opportunities.
“At the end of the day, a successful securities lending programme is dependent upon the ability of the interested parties – beneficial owner, borrower and agent lender – to work within regulatory and business bounds to identify a risk-return balance that is right for all involved. When regulatory changes shift the ground – for example, by implementing rules that drive up demand for certain types of collateral – participants may need to adjust fees, adapt on collateral acceptability and make lending decisions in the broader context of an organisation’s own liquidity and balance sheet requirements.”
The penalty framework around settlement is also causing problems, particularly the lack of clarity around the imposition of mandatory buy-ins after four days, with the industry calling for Esma to delay the mid-2015 deadline and consider the two tier market that would ensue.
“Prospective movement toward central counterparty settlement is another example,” adds Ferguson. “A move to central counterparties (CCPs) would require participants to re-evaluate risk-return equations to account for additional costs associated with CCP settlement as well as the inability to assess each individual counterparty in a given trade.
“Securities lending programmes will remain an important source of riskadjusted return for many beneficial owners, a key tool for many investment managers and an enabler of healthier liquidity. Achieving securities lending success in tomorrow’s regulatory and market environment will require all participants to clearly understand the expectations and impacts of regulation not only on their own businesses but on those of their fellow stakeholders.”
Once fully implemented, the Basel III framework will improve banks’ resilience to asset and liquidity stresses and shocks, but it is too soon to conclude that the industry has achieved stronger creditworthiness, according to ratings agency Moody’s.
The agency has issued a report that notes that banks have made substantial improvements in their fundamentals, including reductions in leverage, the implementation of firm-wide stress testing, and the formation of more robust liquidity and funding profiles.
“Yet,” the report says, “many banks remain challenged in meeting full Basel III requirements while, at the same time, sustaining profitable business models under these more stringent regulatory constraints.” Liquidity in the marketplace has already fallen sharply.
“The regulations reduce the ability of banks to fund client transactions which in turn reduces their ability to finance activities in real business,” says Josh Galper, managing principal of securities-lending consultant Finadium.
“It restricts the real economy in the end. Credit intermediation is risky but necessary to finance the real economy. Whether the regulators will pull back depends on how much the real economy is hindered from growing. This is a big, big deal.”
Indemnification
The Financial Stability Oversight Council (FSOC), a group of regulators that keeps an eye out for emerging risks, believes indemnification agreements – the common practice whereby the agent offers default indemnity to compensate clients if a borrower fails to return a security that some view more valuable than the collateral held by the lender – could be risky for asset managers, which do not face the same capital and liquidity requirements as banks.
A report it issued earlier this month suggests this will be tackled by the FSB’s proposed framework for more intensive supervision of large financial institutions like funds. However, without indemnification, beneficial owners may well shy away from the market, which would also impact market liquidity.
Nervous
Large asset managers are nervous. BlackRock has anticipated the move in a paper sent to regulators that attempts to demonstrate that the firm has sufficient liquidity to meet its indemnification needs. The asset manager also points out that the regulators overstate the risks because the agreements only kick in when a borrower defaults, which is anyway rare, and asset managers then pay only the difference between the value of the security and the collateral.
The annual report of the Treasury Department’s risk council, published in May, also alluded to this but did not name any firms. There will be other major loose ends to tie up after the November summit. The Basel Committee is expected to consult on how to standardise the diversity of ways that lenders use to calculate risks from assets to calculate capital adequacy buffers. This follows scepticism on the part of UK and US regulators over how banks arrive at risk-weighted asset totals.
The proposed measures from the European Commission aimed at increasing thetransparency of transactions in the shadow banking sector, generally referred to as the reporting and transparency of securities financing transactions will require detailed reporting on these operations and that all transactions are reported to a central database.
This is still in the first phase of a European council ministers working group, the beginning of the process, and will take a year to negotiate. The other important feature of this piece of regulation is the requirement to obtain the permission of the lender for any rehypothecation.
“The consequences of the regulation are intended – the amount of focus on securities lending and repo are, I suggest, deliberate,” says Richard Metcalfe, director of regulatory affairs at the IMA.
“Additional reporting and greater transparency is not in itself objectionable but we are concerned that the implementation should be as proportionate as possible. If you look at derivatives reporting which is the main experience we have to go on, the European regulator went further than the US in its requirement on both sides to report. The European policymakers prefer to err on the side of capturing too much information, rather than too little.”
