Moderating leverage in the financial markets – are haircuts the answer?

Moderating leverage in the financial markets – are haircuts the answer?

By Simon Hills, Director, Prudential Policy, UK Finance

A report on January 12 in the Financial Times reminded me about the IOSCO consultation on the use of leverage by asset management firms. It identifies the risks to financial stability that leverage may pose and how to monitor it in those funds identified as being systemically important.

Over the past decade global assets under management have grown to $77 trillion, or about 40 per cent of the global financial system’s assets, making them a force to be reckoned with. But it is important to recognise that asset managers pose different risks to banks and insurers, which normally act as principal to a transaction. Asset managers act as agents, intermediating on behalf of their clients who actually own the assets

Leverage is one area in which, theoretically at least, the largest asset managers, including hedge funds, could create systemic risk. Leverage enables them to boost expected returns by using derivative or securities financing transactions (SFT), for instance, but if the markets move unexpectedly, leverage within a fund increases the risk of financial distress. This could then be transmitted to the broader financial system, including the asset manager’s direct counterparties such as banks and brokers with which it trades derivatives, or which have extended securities financing to it via reverse repos. Indeed, the Financial Policy Committee’s last Financial Stability Report raised concerns about the build-up of derivative created leverage in the non-banking system, although it concluded that it appeared to have sufficient liquid assets to cover the posting of variation margin on their OTC interest rate derivatives.

I believe in the cleansing disinfectant of greater disclosure. Asset managers should disclose to their investors and report to their supervisors on the amount of leverage they are employing, in much the same way that banks are required to make Pillar 3 disclosures about many aspects of their risk profile.

In the meantime, the Basel Committee on Banking Supervision (BCBS), the group which sets internationally recognised prudential standards, has been looking at this issue through the other end of the telescope. The recently finalised Basel III framework (known by some as ‘not Basel IV’ because of the wide-ranging changes it will introduce by 2022), penalises banks providing SFTs to asset managers. It requires them to hold overly conservative prudential capital against SFTs that are not centrally cleared by flooring minimum collateral haircuts for exposures to SFTs. Despite the international regulators’ intention being to reign in the provision of leverage to unregulated counterparties, the minimum haircut floor for SFTs includes transactions with regulated entities too.

This will impact on banks’ willingness to support their asset management customers’ SFT transactions. In turn, this will reduce liquidity in the capital markets and asset managers’ ability to support long-term economic growth by intermediating between companies and investors in the capital markets.

It is important that the BCBS reconsiders the application of the minimum haircut floors to SFTs undertaken by regulated asset managers. This is precisely the message of a letter recently sent by the International Banking Federation to the BCBS, a letter which is fully supported by UK Finance. I look forward to the proposals on the minimum collateral haircuts for exposures to SFTs being improved.

UK Finance represents nearly 300 of the leading firms providing finance, banking, markets and payments-related services in or from the UK.

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