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State Street’s Digest of
Topics in Securities Finance
In View
ISSUE 3
Capital Cost Implications of Pending and Proposed
Regulatory Changes
AUG. 2014
In View Series
As one of the world’s most experienced
lending agents providing both custodial
As we noted in our first In View article entitled, “The Value and Cost of Borrower
Default Indemnification,” it is our intent to more fully explore the potential impact of
pending and proposed regulatory changes on common securities finance
transactions. In this article we explore four lending scenarios in detail to give the
reader a better sense of how the regulatory changes are likely to affect both agent
banks and prime brokerage firms. It continues to be our hope that these pieces will
provide industry participants with a firmer foundation for open dialogue about optimal
lending program structures.
and third-party lending, State Street
offers the individualized service, clientfacing technology and commitment to
transparency you’re looking for.
Whatever the market conditions, our
dedicated team can work with you to
design a program within a framework
tailored to your return objectives and
risk appetite. The In View Series
A CHANGING LANDSCAPE
highlights topical issues for today’s
securities finance market.
Post financial crisis we have entered a period of increased regulation of both banks
and financial market activities. As Basel III and the Dodd-Frank Act are
implemented, banks will be faced with increased capital requirements and leverage
constraints. These requirements will have a direct impact on the securities lending
industry. The securities lending market has historically followed a basic value chain
with beneficial owners providing supply and end borrowers bringing demand. In
between these two parties, agent lenders have aggregated supply and prime
brokers have aggregated demand. Additionally, the agent lenders and prime
brokers have added both trading and operational efficiency and have provided
credit intermediation.
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Authors
Glenn Horner, CFA, FRM
Up to this point, regulatory capital requirements for these intermediaries have not
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constrained growth. Agent lenders generally are required to hold capital against
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risk weighted assets that are incurred as a result of the indemnities they provide.
Jeffrey Trencher, CFA
Under Basel I and II, the amount of required capital relative to revenues generated
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was fairly low since agent lenders were able to rely on value-at-risk models that
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reflected correlation and diversification benefits within a portfolio of loans and
collateral. Under the Dodd-Frank Act, U.S banks will have to calculate risk-weighted
assets (“RWA”) in two ways: using an advanced methodology (VaR-based for
securities lending) and a standardized approach (currently proposed
as a simple haircut on loaned securities, collateral securities, and FX exposures).
For securities lending transactions the standardized approach may result in RWA that are many multiples higher than both the
advanced approach and the currently employed methodology (Basel I). This additional capital will increase the cost of agents’
provision of indemnification and may result in supply and cost changes for assets made available to prime brokers.
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Prime brokers are also incurring increased capital requirements under Basel III and the Dodd Frank Act. Prior to the financial
crisis, the five largest U.S. prime brokers were independent investment banks and were not subject to regulation by the U.S.
Federal Reserve or the Office of the Comptroller of the Currency (“OCC”). Since the crisis, four of these prime brokers have
either become directly regulated by the Federal Reserve, or have been acquired by an entity regulated by the Federal
Reserve. The remains of the fifth entity, Lehman Brothers, are now part of Barclays, which is regulated by the Bank of
England. As such, the major U.S. entities are all now regulated by either the Federal Reserve or the OCC and will have to
comply with Basel III. In terms of non-U.S. prime brokers, most of the largest participants were regulated by their local banking
regulatory authorities prior to the financial crisis. New requirements under Basel III will significantly increase their capital
requirements for securities borrowing and lending as well.
The largest prime brokers will face similar issues with RWA as will agent lenders, however, the bigger regulatory capital issue
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for these entities will be the introduction or enhancement of leverage ratio requirements. In addition to the Tier 1 capital ratio
requirements, Basel III introduces global leverage ratio requirements under which Tier 1 capital must be a minimum of 3% of
assets (plus certain off-balance sheet exposures). This base requirement will be new for non-U.S. banks. U.S. banks have been
subject to a leverage ratio test for some time, but the largest U.S. banks will be faced with even tougher requirements. The eight
global systemically important banks (G-SIBs) within the U.S. will have a 5% minimum required Tier 1 capital ratio at the bank
holding company level and 6% minimum required Tier 1 capital ratio at the depository institution level.
SAMPLE TRANSACTIONS
As a means of giving some context to the above discussion, we present four sample transactions from the perspective of both the
agent lender and prime broker (the borrower). In addition to estimating the capital that will be required and the associated
potential funding cost, we estimate the revenue threshold that will need to be achieved to compensate each of the
intermediaries for these costs.
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For this exercise, we assume that RWA will be calculated using the standardized approach. We also assume both the agent
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lender and the prime broker have established a 10% target risk-based capital ratio , which is in excess of the minimum required
level. Additionally, both the agent lender and the prime broker have a 10% return on capital target or, looking at it another way, an
assumed cost of capital of 10%. Leverage assets (adjusted assets for leverage computation purposes) for the agent lender
are calculated as current exposure, i.e., the value of the loaned security less the value of the collateral. As long as the
collateral value exceeds the value of the loaned security the agent’s current exposure is zero. Given agents’ normal business
practice of holding excess collateral, we have not included its leverage ratio information in the below table. Leverage assets
for the prime broker are calculated as nominal exposure (loan value) plus current exposure (margin).
For the agent, the mandated RWA calculation for an indemnified loan is equal to the upwardly-adjusted loan value (our term) less
the downwardly-adjusted collateral value (also our term), where the adjustments are defined by the regulatory haircuts for each
asset type. In this calculation, the RWA represents a “worst case” estimate of the possible collateral value shortfall as the loan is
assumed to move up sharply in value and the collateral is assumed to move down sharply in value.
1
As a refresher, Tier 1 capital is defined as the sum of common stock, non-redeemable preferred equity, retained earnings and disclosed
reserves. The Tier 1 capital ratio is equal to Tier 1 capital divided by risk-weighted assets.
2
RWA= Exposure at Default (EAD) x Counterpart Risk Weight. For purposes of this analysis we assume a counterparty risk weight of 100%.
Therefore RWA = EAD
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The risk-based capital ratio is defined as (Tier 1 + Tier 2 capital) / RWA.
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The following diagram demonstrates this for the loan of an S & P 500 stock versus an S & P 500 stock taken as collateral
(Example 4 in this paper).
Agent Lender
S & P 500 vs. S & P 500
Collateral adjusted from $108 to $96.55
Starting collateral value at $108
Loan adjusted from $100 to $110.60
Starting loan value at $100
Total RWA measured from $96.55 to $110.60
RWA calculation encompasses extreme high and low values from collateral and loan calculations
94
96
98
100
102
104
106
108
110
For the prime broker, the RWA calculation is equal to the upwardly-adjusted collateral value less the downwardly-adjusted loan
value. In this calculation, the RWA represents a “worst case” estimate of the possible loan value shortfall; the prime broker is
holding an asset (the loaned security) with a value far less than the collateral it pledged and would be subject to this shortfall
should the beneficial owners default.
This following diagram demonstrates this same transaction from the point of view of the prime broker.
Prime Broker
S & P 500 vs. S & P 500
Loan adjusted from $100 to $89.40
Starting loan value at $100
Collateral adjusted from $108 to $119.45
Starting collateral value at $108
Total RWA measured from $89.40 to $119.45
RWA calculation encompasses extreme high and low values from collateral and loan calculations
88
93
98
3
103
108
113
118
112
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In all cases the RWA is meant to represent the worst-case scenario of one’s trading counterparty not fulfilling its obligation (to
return either collateral or the loaned securities) and being left with an asset negatively impacted by a downward or upward market
move. Since positive collateral margin is almost universally provided in a securities finance transaction by the borrower, the agent
will have a lower RWA than the prime broker for a given transaction.
Standardized Approach
4 Transaction Examples
Example
Loaned Securities
Loan
Amount (M)
Haircut
Collateral
Type
Collateral
Amount (M)
Haircut
1
S&P 500 stock
100
10.60%
Cash
102
0%
2
Sovereign Bond
100
2.83%
Cash
102
0%
3
S&P 500 stock
100
10.60%
Sov. Bond
105
2.83%
4
S&P 500 stock
100
10.60%
S&P 500 stock
108
10.60%
RWA Formula (Lending Agent)
Haircut Adjusted Loan Value - Haircut Adjusted Collateral Value = RWA
(Loan Amount x (1 + Haircut)) - (Collateral Amount x (1 - Haircut)) = RWA
RWA Formula (Prime Broker/Borrower)
Haircut Adjusted Collateral Value - Haircut Adjusted Loan Value = RWA
(Collateral Amount x (1 + Haircut)) - (Loan Amount x (1 - Haircut)) = RWA
RWA Calculations
Example Transaction (Loan vs. Collateral)
For Lending Agent
Haircut-Adjusted
Haircut-Adjusted
Loan Value ($) Collateral Value ($)
For Prime Broker
Haircut-Adjusted Haircut-Adjusted
RWA ($)
Collateral Value ($)
Loan Value ($)
RWA ($)
1
S&P 500 stock vs. Cash
110.600
102.000
8.600
102.000
89.400
12.600
2
Sovereign Bond vs. Cash
102.830
102.000
0.830
102.000
97.170
4.830
3
S&P 500 stock vs. Sovereign Bond
110.600
102.029
8.572
107.972
89.400
18.572
4
S&P 500 stock vs. S&P 500 stock
110.600
96.552
14.048
119.448
89.400
30.048
Use color coding so as to more easily follow the calculation
The following table estimates the minimum loan spread required to cover the associated cost of capital for each of the transaction
examples. As noted, a target risk based capital ratio of 10% is assumed as is a 10% cost of/return on capital. For cash
collateralized loans, a reinvestment spread of 15 bps is assumed. The agent’s minimum demand side required return is the
cost/return on capital less the agent’s portion of any cash reinvestment earnings adjusted for the assumed 80%/20% fee sharing
arrangement.
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Assumptions
Target RBC Ratio
10%
Target Return on Capital (Cost of Capital)
10%
Fee Split
80%
Agent
Required
Capital for
RWA
Example 1
S&P 500 stock
vs. Cash
Example 2
Sovereign Bond
vs. Cash
Example 3
S&P 500 stock
vs. Sov. Bond
Example 4
S&P 500 stock vs.
S&P 500 stock
RWA ($)
8.600
0.830
8.572
14.048
Target RBC @10% ($)
0.860
0.083
0.857
1.405
Cost/Return on Capital @10% ($)
0.086
0.008
0.086
0.140
Cost/Return on Capital (bps)
8.600
0.830
8.572
14.048
15.000
15.000
0.000
0.000
Agent’s portion of Cash Reinvest (bps) (20%)
3.000
3.000
0.000
0.000
Agent's Demand-side Req. Return (bps)
5.600
0.000
8.572
14.048
Min. Required Demand Spread to Cover
Agent's Target Return on Capital (bps)
28.000
0.000
42.858
70.240
RWA ($)
12.600
4.830
18.572
30.048
1.260
0.483
1.857
3.005
Cash Reinvest (bps)
Prime Broker
Required
Capital for
RWA
Target RBC ($)
Cost/Return on Capital ($)
Leverage Ratio
Req Spread
to client
0.126
0.048
0.186
0.30
Cost/Return on Capital (bps)
12.600
4.830
18.572
30.048
Balance Sheet Asset Increase ($)
102.000
102.000
5.000
8.000
Required 5% Tier 1 Capital ($)
5.100
5.100
0.250
0.400
Required Return on Capital ($)
0.510
0.510
0.025
0.040
Required Return on Capital (bps)
51.000
51.000
2.500
4.000
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RESULTS
Example 1: A large-cap U.S. equity is loaned versus U.S. cash collateral
For the agent, the trade will require a minimum demand spread (i.e., below-the-line spread) of 28 bps to cover its capital costs.
For the prime broker, the binding constraint is the capital required to support its incremental leverage rather than that required to
support its RWA (treatment discussed in Example 3).
Prime brokers manage the leverage impact of their securities borrowing and repurchase agreement portfolios by netting
exposures with the same counterparty. Such netting can be accomplished under Basel III if certain contractual conditions are
met: transactions must have the same explicit final maturity, a legally enforceable netting agreement must be in place, and the
counterparties must intend to settle accounts receivable and payable on a net basis of the functional equivalent. Therefore, in
this example the prime broker may be able to significantly reduce its required return from a leverage perspective by employing
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Non US institutions will have a 3% requirement
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such netting tactics. With the increased capital requirements due to new leverage regulations we anticipate prime brokers will
look to increase their use of such strategies.
Example 2: A 10-year sovereign bond is loaned versus cash collateral in the same currency as the loan
For loans of securities requiring smaller regulatory haircuts, the return from cash reinvestment may be sufficient to cover the
agent’s capital costs. However, as it is quite common for cash collateral received versus fixed income securities to be invested in
indemnified repurchase agreements, the return from cash reinvestment may be significantly lower. As was the case in Example
1, the leverage ratio is the binding constraint in this example as well.
Example 3: A large cap U.S. equity is loaned versus a 10-year sovereign bond (U.S. Treasury)
Even “lower risk” non-cash collateral transactions can increase the capital requirement for the agent lender, however, such a
trade may well generate a spread that is lower than a cash collateralized trade given the contribution from cash reinvestment
earnings. As demonstrated in this example, the minimum demand spread from the securities loan needed for the agent to meet
its required return on capital is significantly higher than is the sample cash trade shown in Example 1.
In this example the binding constraint for the prime broker is its risk based capital requirement and not its leverage limitation. The
leverage ratio will be much less impacted given that non-cash borrows are off-balance sheet under U.S. GAAP provided that the
securities are not re-hypothecated. In this case, the required leverage assets of $5 are simply the current exposure amount, i.e.,
the collateral value less the loan value.
Example 4: A large cap US equity is loaned versus another large cap US equity
This example clearly demonstrates that the equity versus equity trade requires a significant return (70bps) to cover the agent’s
capital costs. Here again the prime broker’s binding constraint for this transaction is its risk based capital requirement and not
its leverage requirement. At the overall firm level many prime brokers have cited the leverage ratio as their primary constraint,
so given the benefit of using equity positions they have on hand, we should expect them to continue to see value in this trade.
This may not be the case for the agent lender.
CONCLUSION
Changing regulations related to banks’ risk based capital and leverage requirements will increase the required return for both
agent lenders and prime brokers in order for these entities to meet their return on capital hurdles for securities lending
transactions. While the outlook may appear challenging, some good news on the regulatory front has come out in the last
couple of months. On the RWA side, the Basel Committee on Banking Supervision (“Basel”) has indicated that it will review the
credit exposure measurement methodology for securities financing transactions (“SFTs”). While the industry waits for a new
proposal for this calculation, there is some optimism that a revised methodology may bring the agent lenders’ required return for
many transactions closer to the current fee levels within the market. On the leverage front, Basel has allowed netting of
transactions that is mostly in line with U.S. GAAP under FIN 41. This will enable prime brokers to net down certain cash based
transactions, which would also bring their required return closer to current market levels for many transactions.
Even with these positive outcomes there will be heightened pressure on return to capital for agent lenders and prime brokers that
may make certain transactions in their current form less attractive. As a result, market participants are actively exploring new
trade structures and alternative routes to market, such as central counterparties. In order for beneficial owners to continue to
optimize their securities lending programs it will become increasingly important to expand flexibility around trade structures,
collateral types, loan and reinvestment terms, and potential new trade routes. As we noted at the outset, these will need to be
consistent with the beneficial owner’s risk/return preferences.
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