Basel III and the Impact on the Collateral Services Industry

by Saheed Awan Jun 10, 2011

In the first instalment of a two-part series, GCMS’ Saheed Awan explains the likely implications of Basel III on collateral management activities including liquidity management.

The upgrade to the Basel II reforms contains numerous implications and strategies for collateral/margin management, repurchase agreements (repo) and securities lending.  Whilst teasing out these implications is a matter of interpretation, there will be certain highly probable outcomes impacting collateral activities in the years ahead, with potentially fundamental consequences on the business models of collateral services providers, software vendors and, of course, on market players themselves.  This is the first of two articles on the likely impact of the reforms in which we will try and identify the winners and the opportunities that will open up to those fast and willing enough to deal with the changes.  

Basel III is part of the perfect storm of regulations and reforms over the next 18 months  with one inevitable result - a drag on the return on shareholder capital in financial institutions, including that of the tax payer.*  Regulations are generally backward looking and Basel III is no exception.  This upgrade to Basel II is designed to address (some of) the causes of the financial crises.  Basel III brings new rules in four areas: capital quality, capital requirements, leverage ratios, and liquidity ratios. Specifically it will require banks to increase their capital and gives a framework for liquidity risk management under stressed scenarios.  Institutions with large capital markets businesses will undoubtedly feel the impact of the upgrade most heavily. Increased capital will need to be set aside for trading books, securitisations, securities finance, and OTC derivatives.  The new liquidity standards will increase demand for sovereign and supranational issued paper and reduce reliance on wholesale sources of funding.

There will be winners though. The regulators favourite - central clearers - could be one and banks with strong retail networks and a stable depositor base could be major winners if they set themselves up as net providers of liquidity to the cash starved wholesale markets, against collateral of course. 

Liquidity! Liqudity! Liquidity!
For many institutions, the liquidity challenge in Basel III is expected to be greater than the increased capitalisation challenge.  As was clearly evident during the financial crises, liquidity risk is probably the most significant of all business risks in that the inability to fund withdrawals over a sustained period, or to fund positions imminently, can lead directly to insolvency.  Basel III sets out two minimum standards for liquidity risk management:

a. the Liquidity Coverage Ratio (LCR), which is designed to promote the short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for 30 calendar days; and

b. the Net Stable Funding Ratio (NSFR) that has been put in to promote resiliency over longer-term horizons by creating additional incentives for banks to fund their activities with more stable, longer tenor sources of funding.

There are two categories of liquid assets, Level 1 and Level 2 assets, which qualify for the numerator of the ratio. There are a number of rules and restrictions and rules on what Level 1 and Level 2 assets should be:

• Ideally be central bank eligible. 
• Should be under the control of treasury or a repo desk whose main function is firm financing
• Should be unencumbered assets and not be co-mingled with or used as hedges on trading positions, designated as collateral or for credit enhancement  (i.e. margin for Over-the Counter (OTC) derivative exposures).
• Corporate bonds rated AA- or higher qualify as liquid assets and are assigned a 15% haircut under the Level 2 bucket. Covered bonds such as high-quality Pfandbriefe will be subject to a 20 to 40 percent “haircut” in the calculation of liquidity.
• Cash equities are not recognised as being a source of any stable secured funding during a short-term crisis.  They can however be used, together with gold, in the Level 2 bucket but with a haircut of 50 percent.

Potential impacts part I
Not surprisingly the liquidity coverage ratio (LCR) has attracted considerable criticism from the banking lobbyists.  Their concerns are understandable.  It is estimated that European banks will need approximately EUR2 trillion in qualifying liquid assets to meet the new regulations.  This is on top of the growing need for such assets for the high initial margins required by central counterparty clearing (CCP) for derivatives - which is estimated by some to suck in over EUR1.4 trillion of high quality sovereign paper globally.  Mike Barrett, a fellow partner in GCMS, has been talking about an upcoming collateral crunch for the last eighteen months and we are now getting some numbers of what he forecasts.

Although the increased capitalisation and liquidity ratios may be subject to recalibration, what specific implications can we draw out from the proposed rules as they stand for the collateral trading and collateral management industry?  Here are a few to get us going in what we hope will be an on-going discussion in DerivSource:

• It is highly probable that there will be reduction in inventories of less liquid assets such as low credit quality market instruments - thus reducing the liquidity of those markets and reducing the repo financing of such inventories.  The tri-party repo structure, which was traditionally used for refinancing such inventory, is therefore unlikely to see a return to higher volumes of such collateral, including equities.  Similarly demand for assets that are currently eligible for central counterparty clearing but are not central bank eligible may be negatively impacted.
 
• If repo/collateral trading activities are going to be focused on bank financing and liquidity management (which is really a dull and boring business) and less on the more interesting and revenue generating side because of balance sheet and regulatory constraints, than this will have consequences for downstream collateral management activities.  Sophisticated collateral management tools touted by software vendors and triparty service providers could sit idle or under used if their users or target market was primarily repo finance desks.  Tools like complex collateral eligibility screening, concentration limit checking, collateral re-use and even optimisation routines become less useful if the main types of collateral assets in demand are going to be from a limited universe, restricted and prescribed by regulatory and central clearing counterpart eligibility rules. However, as we shall see in the following article, refocusing the development and marketing resources of collateral services providers to collateral transformation/upgrade functionalities, to margin management of client clearing, to new geographical markets and even to the non-financial sector could well become the new areas of growth for sophisticated collateral management tools, many of which I pioneered over the last eighteen years.  But the world has changed and the straight jacket of the new regulations will probably end up making collateral management generally a more simpler process.         

• Collateral re-use or rehypothecation has been much criticised by regulators, primarily due to the Lehman Brother’s default.  To qualify as a Level 1 liquid asset, the new Basel rules state that the asset must be "unencumbered". The only exception to re-use in the new rules are "assets received in reverse repo and securities financing transactions that are held at the bank, have not been rehypothecated, and are legally and contractually available for the bank's use can be considered as part of the stock."  This clearly rules out the re-use of collateral received for credit support or margin against OTC derivative exposures.  What is less clear is if this means collateral received in a reverse repo trade can be used for on-pledging to, for example, a central bank?  To be able to do this the party reversing in the bonds may require an absolute guarantee that their counterpart has not used rehypothecated bonds. Who will provide such an assurance or guarantee - will it be a central clearing counterparty if that is the route taken for the reverse repo trade?  And what do the proposed rules on restricting or limiting re-use mean under the commonly used English law industry legal agreements?  Do the proposed restrictions not constitute a "recharacterisation of risk", a legal phrase that constantly bugs the collateral industry?

Given all these questions, it will be useful for the industry to get clarity on these issues before the regulatory reforms are imposed. Financial institutions will, however, need to start preparing for compliance with these new rules now and such compliance will present challenges to current business models of securities lenders and collateral management operations.

 

* In the second part of this article series, Saheed Awan will look at the potential winners and more on the challenges presented to the business models of securities lenders and collateral management operations.

 

Notes:

* New regulation impacting the financial services sector includes: Dodd-Frank Wall Street Reform & Consumer Protection Act (Dodd-Frank), European Marketing Infrastructure Regulation (EMIR), Markets in Financial Instruments Directive (Mifid II) and Solvency II.

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Saheed Awan, Partner
Global Collateral Management Solutions, LLC

 

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Comment: 

This a recent instalment of a series on Collateral Management published exclusively by DerivSource. Please see previous articles as part of this series running from August 2010 until now:

OTC Derivatives Collateral Management: Best Practices & Beyond - August 2010

Pension Funds: Improving Collateral Management for OTC Derivatives through Governance, Software or Outsourcing - Sept 2010

The Buy Side Gets Proactive: Improving Portfolio Reconciliation of Collateralized OTC Derivatives - October 2010

Securities Lending: A Business Opportunity in Collateral Management - November/December 2010

Sell-Side Perspective: The Challenges and Benefits of Collateral Optimisation - January 2011

Exploring Title VII of the Dodd-Frank Act & the Impact on Margin Posed by End Users - Feb/March 2011

Custodians Gearing Up to Support More Complex Collateral Management Needs of Buy-Side Clients - May 2011

* If you wish us to cover a specific aspect of collateral management or counterparty risk mitigation practices, please feel free to get in touch at editor@derivsource.com