February 2016 | Volume 14, Issue 2
Contents
2
8
10
Rule delays
eat into MiFID
postponement
Market participants
seek to revive
single-name CDS
Community
banks challenge
FASB to make
accounting reform
scalable
US regulatory
round-up
Harmonisation
is key obstacle
to EU securitisation
revival
Banks still
question new
trading book rules
12
14
16
Newsroom (18-21)
Fund manager alarm
at planned liquidity
rules; EU urged to
expand net stable
funding ratio; US living
wills prompt funding
questions;Transparency
key to EU stress test;
Fed hikes credit losses
in 2016 stress test
scenarios; EU promises
proportionate stance;
Pressure grows on
leverage ratio
22
23
EU wades into
insurance
systemic risk debate
Insurers ask for
continuity on
resolution planning
globalriskregulator.com
Pressure grows for more
proportionate bank regulation
While smaller EU banks look to the US as a model for lighter
reporting requirements, new entrants are more active in Europe.
By Philip Alexander
With the European Commission consulting on
the cumulative impact of the EU financial regulatory framework, bodies representing smaller
banks are pushing for greater proportionality,
especially in the Capital Requirements Directive
(CRD IV). The European Banking Authority’s
(EBA) banking stakeholder group published a
position paper on proportionality in December
2015. This criticised excess complexity and a
lack of regulatory differentiation, especially on
reporting requirements, for banks that are not
systemically important.
“The Basel rules were initiated to increase the
capital of the global banking institutions, but the
EU has chosen to apply them to everybody. As
a smaller institution, that already puts you on the
defensive because these are regulations that were made for much
larger institutions, and there is
also a tendency for the supervisory agencies to go further at Level
2 than the legislative text intendChris de
ed,” says Chris de Noose, managNoose
ing director of the World Savings
Bank Institute and one of the paper’s authors.
The report recommended introducing proportionality into Level 1 legislative texts and into
the supervisory process, targeting both the prudential requirements such as capital, liquidity and
resolution planning, and reporting requirements.
It also urged the European Commission to create
a proportionality task force, while to page 4
Basel credit rules grapple
with national differences
The Basel Committee is struggling to reconcile the desire for global
standards for calculating credit risk with differing national legislation
and loss experiences. By Philip Alexander
Credit risk-weighted assets (RWAs) account
for the vast majority of most banks’ balance
sheets for the purpose of calculating their
Basel capital ratios. Moreover, whereas the
trading book is a significant business only for a
small group of global systemic banks, the banking book is the core of almost all banks that
adhere to the Basel standards. Consequently,
the Basel Committee on Banking Supervision
(BCBS) has faced acute challenges ensuring
that its proposed revised standardised approach to calculating credit RWAs is appropriate for all the banking sectors where it
would be applied.
Stefan Ingves, the BCBS chairman and head
of the Swedish central bank, acknowledged in
October 2015 that responses to the first consultation – launched in December 2014 – had
underscored the difficult dilemmas that needed addressing. In
particular, because the BCBS is
also consulting on using standardised approaches as floors
for the outputs of the internal
Stefan
ratings-based approach (IRB),
Ingves
the most sophisticated banks
are keen for the standardised approach to incorporate in some way the risk sensitivity embodied in IRB models. But many second and
third tier banks will only use the standardised
approach, and need it to be simple enough to
suit their data resources and business models.
“In this case, striking the right balance between simplicity and risk sensitivity involves
fairly clear trade-offs. What we proposed last
December aimed to introduce
to page 6
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VIDEO Brian Caplen asks former Barclays
chairman Sir David Walker about the contents
of a G30 report on banking conduct and culture
2
Rule delays eat into
MiFID postponement
Market participants say the extra time that a 2018 start will
allow can only help if the final details are available imminently.
By Philip Alexander
The European Commission ended months
of speculation in February 2016, and officially announced a one-year postponement
to the implementation of the Markets in
Financial Instruments Directive (MiFID II)
to January 2018. The European Parliament
signalled reluctant approval of the request
by the European Securities and Markets
Authority (ESMA) in November last year.
However, that support was conditional on
a “clear roadmap on the implementation
work”.
“Given the complexity of the technical
challenges highlighted by ESMA, it makes
sense to extend the deadline for MiFID
II. We will therefore give people another
year to prepare properly and make the
necessary changes to their systems,” said
Simon Maisey
“In practice, the
framework of
rules requires that
everything is done
in one go”
Jonathan Hill, European Commissioner for
financial services, announcing the delay.
The industry is now echoing parliamentarians’ concerns about improving
the organisation of MiFID preparations,
rather than just extending the deadline.
In particular, many of the technological steps that market participants need
to take can only begin once ESMA and
the Commission have finalised technical
standards. In its press release announcing
the postponement, the Commission said
the timeline for adopting the Level two
technical standards had not changed, and
it expected to announce these measures
shortly.
“In the middle of last year, we were
18 months from implementation and still
waiting for the final rules. At the moment,
we are not much better off, because we
are still waiting for the final rules,” says
Mark Croxon, head of regulatory and market structure strategy at the Bloomberg
trading platforms.
The major stumbling blocks revolve
around the financial instruments reference
data (Firds) project required to calculate
many of the key ratios that will determine
thresholds for specific regulations governing pre- and post-trade transparency for
financial instruments. Whereas MiFID I
applied only to equities, MiFID II will take
in every traded asset class, bringing a wide
range of new products into its regulatory
ambit for the first time. The Commission
said that ESMA has to collect data from
around 300 trading venues on approximately 15m financial instruments.
“Everything comes back to the reference data – dark pool caps for equities,
pre- and post-trade for non-equities, and
position limits for commodities. Where
there are legal consequences, for example
to breaching position limits, you have to
make sure that this data is accurate and
reliable. Newly regulated entities such as
commodity firms will not have systems
that are fit for purpose yet,” says John
Ahern, leader of the financial services regulation team at law firm Jones Day and a
former in-house counsel at Merrill Lynch.
Gary Stone, chief strategy officer for
trading solutions at Bloomberg, says investment funds are also having to rethink
their systems quite extensively. Some
are already beginning to “insource” their
MiFID reporting processes that were previously outsourced to their brokers.
“Buy-side firms’ current providers
may not satisfy all MiFID II requirements,
or there are concerns about the sell-side
retaining all the personal data that will be
generated by the new rules. Large buyside firms may have a similar number of internal systems staff to a sell-side firm, but
many smaller businesses are not geared up
for this,” says Mr Stone.
globalriskregulator.com
February 2016
Global Risk Regulator
Simon Maisey, a managing director at derivatives and fixed income trading platform
Tradeweb, says the good news is that institutions have not taken the signals of a
delay to MiFID as a reason to pause their
own preparations. But there are great limits on what can be done until final rules
are in place, and it is difficult to sequence
the work in separate stages as the rules
are very interdependent.
“It would be good from a process
viewpoint to phase in each step, such as
defining the reference data, then using that
definition to gather the individual trade
level data, and then use that to carry out
the necessary liquidity calibration and set
the thresholds. But in practice, the framework of rules requires that everything is
done in one go. For post-trade reporting
to work, you need to know who has to
report each trade,” says Mr Maisey.
That means setting the definitions for
multilateral and organised trading facilities
and the threshold for so-called systematic
internalisers – dealers that operate a certain proportion of trades away from multilateral venues. But the systematic internaliser threshold would itself depend on the
reference data, and that in turn relies on
other definitions.
On pre-trade transparency, one crucial question still to be answered is what
counts as a firm price that must be displayed to all market participants. This is
relatively clear in the case of a central limit
order book (CLOB), commonly used on
stock exchanges, but much less apparent
in fixed income markets that tend to operate on a request-for-quote (RFQ) basis.
“We can anticipate what capacities the
platform will need to some extent, but
we need to know how orders will interact in practice. For instance, what will be
the definition of an indication rather than
a price in terms of the pre-trade transparency rules. Until we know that, it is not
possible to build the complete system,”
says Mr Stone.
Moreover, trade reporting engines
cannot be finalised until all the fields required by regulators have been identified.
National regulators will have opportunities to gold-plate some of these rules because they fall under the directive rather
than the regulation (MiFIR) that requires
maximum harmonisation among EU member states.
February 2016
Getty
Everything is connected
The European Commission hQ
“While some national authorities have
indicated that they will transcribe the 65
MiFID II reporting fields as they are, others are looking at adding anything up to
20 other fields. Until we know the level
of detail required, participants cannot prepare their workflows to capture the extra
fields,” says Mr Croxon.
And this is the challenge purely within the EU. Knowing the implications for
third-country participants is even more
difficult. Mr Stone says EU clients may
begin demanding Legal Entity Identifiers
(LEIs) – one of the key data building blocks
for trade reporting – from their non-EU
brokers to ease MiFID II compliance.
Missing definitions
Another new element of MiFID II is the
attempt to cap the volume of equity trading that can take place away from fully lit
exchanges – so-called dark pool trading.
Any individual dark pool that accounts
for more than 4% of volume in a particular stock on a rolling 12-month basis will
need to temporarily halt unlit trading in
that stock. Moreover, all unlit trading in an
equity will need to stop if more than 8% of
its volume is being traded on dark pools
across the EU.
“There is still a debate about what
types of trade need to be captured for the
dark pool cap calculations. Assuming a rolling 12-month reference period to start imposing the rule from January 2017, then we
needed those definitions already to start
collecting data in January 2016, and those
definitions are different from the way data
is held at the moment. The complication
globalriskregulator.com
was not necessarily insurmountable and
there could have been adjustments after
the go-live date, but providing an extra
year for trading venues to begin to collect
and calculate this data properly is time well
spent,” says Mark Hemsley, chief of BATS
Chi-X Europe, an equity exchange that operates both lit and unlit trading.
The widening of the regulatory remit
from CLOB venues to RFQ also has profound implications for the rules on high
frequency trading that were introduced
into MiFID II at a late stage during negotiations between the European Parliament,
Commission and Council. As currently
drafted, the definition of high frequency
trading could revolve around the ratio
of completed to cancelled orders. This
makes sense in a CLOB context where
orders are placed for execution, says Mr
Maisey, but streaming quotes are indications of liquidity rather than hard orders.
As a result, the ratio of quotes to completed transactions may be higher in RFQ
systems for fixed income instruments
compared with a CLOB for equities or futures, given the liquidity profile. This could
lead to RFQ venues being inadvertently
included without operating activity they
would themselves consider to be high frequency trading.
“If venues find their activity is caught
by this definition, there are substantial obligations including clock synchronisation
and microsecond granularity of the timestamp. That is a high technological cost,”
says Mr Maisey.
However, Mr Ahern points out that
a postponement of the MiFID start date
could also create fresh difficulties that
ESMA and the Commission will need to
address. Foremost among these is that the
MiFID II legislation already on the EU official journal repeals MiFID I at the start of
2017, which could result in a legal vacuum
if MiFID II is only ready to roll out in 2018.
“One possibility would be to revisit
MiFID II to change the implementation
date and allow MiFID I to continue until
then, but that would be politically charged
because it means going through the whole
legislative process again – which could
take more time than the delay itself. There
could be some compromise arrangement
whereby if firms continue to comply with
MiFID I they will be deemed to have complied with MiFID II until it is ready to enter
force,” says Mr Ahern. GRR
3
Global Risk Regulator
Pressure grows for more
proportionate bank
regulation
from page 1
the regulatory agencies such as the EBA
should each have a review group accountable to the head of the agency. The position
paper included a series of case studies of
particular instances where EU regulations
would potentially impose a disproportionate burden on smaller banks.
“It is important to us that these case
studies can be used as a tool. Every time
there is a regulation in the making, every
time a supervisor is trying to implement
a provision, they should check with the
concept of proportionality – it should be
in their mind permanently,” says Caroline
Gourisse, head of regulatory affairs at the
European Savings Bank Group.
David Llewellyn, a professor of money
and banking at the UK’s Loughborough
University and another of the report’s authors, says it is vital that proportionality
is considered at the start and all the way
through the legislative process. That includes a cost-benefit analysis of applying
the rules to banks of specific sizes and business models.
“We recognise that is a difficult calculation, and it will not be very precise, but it
is a powerful discipline for the regulatory
process. It is also important not just to look
at individual regulations, but at the totality:
each rule may be justified, but the collection of rules less so when applied to an institution that is not material on its own,”
says Mr Llewellyn.
Capital calculations
The Basel rules have introduced extra capital buffers for systemic banks, which would
not apply to their smaller peers. Even so,
smaller banks believe they are at a disadvantage. In particular, few have been able
to adopt the internal rating-based (IRB)
approach to calculate how much capital to
hold against credit risks, and must instead
rely on the standardised approach.
“The barriers for a small bank to move
to IRB are extremely high, and it would be
good to see some sort of interim approach
that allowed us to use expert judgement in
our capital calculation. We operate internal models for our own risk management,
but because we are a young bank, we do
not have the depth of statistical loss data
to validate them empirically as is required
4
by regulators under the IRB approach,”
says Will German, chief risk officer at
Cambridge & Counties Bank in the UK.
The bank was set up in 2012 to specialise in
small and medium enterprise (SME) lending.
Cyrus Ardalan is the chairman of another challenger bank, OakNorth, and a
former vice-chairman at the UK systemic
bank Barclays. He says the standardised approaches tend to result in more onerous
capital requirements precisely to incentivise the adoption of internal models.
“In the case of mortgages, capital can
be several multiples higher under the
standardised approach, and there is little
discretion in CRD IV to account for very
different mortgage market characteristics
in different countries,” says Mr Ardalan.
The Bank of England flagged up this
issue in a response to the European
Commission’s July 2015 three-yearly review of CRD IV. According to the UK prudential regulatory authority’s calculations,
for mortgages with a loan-to-value ratio of
less than 80%, the IRB delivers risk weights
of 3% to 15%, whereas the standardised approach leads to a risk weight of 35%.
David llewellyn
“It is important
not just to look
at individual
regulations, but at
the totality”
“Although large banks face additional
capital buffers and are subject to leverage
ratio requirements, this differential creates
an uneven playing field and can have unintended effects on the safety and soundness
of banks by encouraging smaller firms to
compete for riskier mortgages, where the
differentials are less severe,” the Bank of
England warned.
Reporting burden
The Bank of England’s proposed solution
to this dilemma is for a more risk-sensitive
standardised approach to credit risk that
does not produce such punitive capital
charges. This is exactly the intention of a revised standardised approach on which the
Basel Committee on Banking Supervision is
currently consulting (see other cover story). However, this new method could also
be more complex to operate, highlighting
the second major disproportionate impact
of regulation on smaller banks: data and reporting requirements.
“Our bank has a total of 60 staff; that
could be a rounding error in the staff numbers for the compliance department of a
global bank, which could run into thousands. The point is that our operational
structure and technology is much simpler,
so we do not need such a large number
of job functions. The extra reporting burden due to new regulations means extra
costs for writing new business, and that
clearly has competitive implications,” says
Mr Ardalan.
Even for Cambridge & Counties Bank,
which has around 100 risk and regulation
staff equivalent to 10% of its workforce,
keeping up with the constant flow of new
rules is challenging and the overheads are
high for a comparatively simple business
model. Chief executive Mike Kirsopp says
the bank may not be competing with the
largest high street lenders on a macro level, but could be directly challenging them
on individual loan transactions. Customer
numbers in the low thousands generate
many tens of thousands of lines of data,
which goes into the regulatory reporting
machine without necessarily being used in
discussions with the regulator.
“For a niche player, some of the fields
are irrelevant but we still have to fill the
blanks. That means less granular reporting
would help, but it also means that different data fields are necessary for different
banks, so there is no one-size-fits-all answer,” says Mr Kirsopp.
Mr de Noose acknowledges that determining appropriate criteria to identify when
to apply proportionality and on what basis
is not an easy task. This is the reason why
the stakeholder group chose to use case
studies to illustrate possible approaches to
proportionality.
“Both size and business model are relevant: small banks are not systemically important, and some business models naturally have a lower risk profile, which justifies a lower regulatory burden,” says Mr
Llewellyn.
Mr Ardalan suggests it would be sensible not to create a binary cliff effect between banks that face full regulation, and
those facing a lesser burden. Instead, there
might need to be a transitional zone for
banks in the middle of the scale.
There are growing signs that the EBA
is beginning to factor proportionality into
globalriskregulator.com
February 2016
Global Risk Regulator
its thinking on reporting requirements in
particular. In its advice to the European
Commission in December 2015 to adopt
the Basel net stable funding ratio (NSFR),
the EBA recommended introducing the
ratio for all banks, but agreed to explore
further “the possibility of providing smaller
banks with reduced frequency and/or lower granularity reporting requirements.”
However, another EBA opinion in the
same month demonstrated the extent to
which proportionality needs to be integratMark Olson
“Deposit insurance
is there to protect
retail customers,
and that means
stable funding and
public confidence
for the banks”
ed at the very beginning of the legislative
process. The EBA advised the “disapplication” of CRD IV rules requiring deferred
bonus payments to discourage short-termist bank management. This exemption
would apply “for small and non-complex
institutions and for staff who receive only
a small amount of variable remuneration”. But to enable this exemption, the
Commission would need to reopen the
level one legislative text, because it does
not currently allow the EBA to interpret
the rules proportionately.
US example?
European bankers are increasingly looking
to the US as an example of how to introduce more proportionality in EU prudential
regulation. The Dodd-Frank Act included
two thresholds: banks with more than
$50bn in assets (currently around 40) are
deemed systemic, and banks below $10bn
of assets are labelled community banks.
Community banks are subject to state-level
regulation, but also overseen by the Federal
Deposit Insurance Corporation (FDIC) and
licensed by the Office of the Comptroller
of the Currency (OCC).
Systemic banks are regulated by the
Federal Reserve and must face the annual Comprehensive Capital Analysis and
Review (CCAR) stress test. Banks below
$50bn face a simpler stress test, and those
below $10bn face no mandatory test. In
addition, banks below $50bn are exempt
from drafting so-called living will resolution
February 2016
plans, and from mark-to-market valuation of securities. They also have a simpler
methodology for calculating risk-weighted
assets to measure their capital ratios. Banks
below $10bn are also exempted from the
Volcker Rule that prohibits proprietary securities trading by entities that enjoy federal deposit insurance.
Mark Olson, the chairman of financial
consultancy Treliant Risk Advisors who
has served as a Federal Reserve governor and as chief executive of a local bank
in Minnesota, says there are signs the
Volcker Rule is pushing banks in the $10bn
to $50bn bracket out of securities trading.
But in other activities, he believes it is still
quite possible to run a sustainably profitable small bank if the market and management are right.
“Small banks need to find their niche
where they can make an impact, to offer
personal service in local markets where the
largest banks have become increasingly impersonal. That said, interstate bank ownership only started 30 years ago, so there are
still just under 6,000 banks in the US and
consolidation is ongoing,” says Mr Olson.
Christopher Cole, senior regulatory
counsel at the Independent Community
Bankers of America organisation, estimates
that there are 200 to 300 mergers per annum. In that context, the position of community banks has become highly politicised
despite the Dodd-Frank differentiation. Jeb
Hensarling, the Republican chairman of the
House of Representatives financial services
committee, has held a number of hearings
on the subject and proposed legislation
to reduce the burden. Most recently, he
seized on a January 2016 research report
by the Dallas Federal Reserve which noted
that “smaller community banks are finding
it increasingly tough to survive, due in part
to the compliance costs needed to deal
with the new regulations”.
“One-size-fits-all regulations do not
work. And what’s worse is that it’s hurting community banks and credit unions and
the hardworking Americans on Main Street
who rely on them,” Mr Hensarling said in
response to the Dallas Fed report.
Trickle down
Mr Cole says the transition to Basel III in
the US is leading to higher capital requirements for community banks, even though
implementation has been differentiated.
And there has also been a trickle-down of
stress-testing practices, which pushes up
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the cost of data management and compliance disproportionately for banks whose
cost base is naturally smaller.
“There is no legal requirement for banks
below the $10bn threshold to stress test,
but state examiners are increasingly encouraging banks to undertake a test every
year or two years, especially for exposures
considered higher risk such as commercial
real estate. Often those tests are carried
out with twinned teams of regulators from
the state commission and the federal authorities such as the FDIC and OCC,” says
Mr Cole.
Mr Olson agrees that there is sometimes an overemphasis on capital strength
compared with the relatively low-risk exposures many smaller banks hold. He argues,
however, that the cost of additional regulatory burden must always be offset against
the reason for it: federal deposit insurance.
Christopher Cole
“State examiners
are encouraging
banks to undertake
a test every year or
two years, especially
for exposures
considered higher
risk”
“Deposit insurance is there to protect
retail customers, and that means stable
funding and public confidence for the banks.
Those are tremendous benefits, and it is important to recognise that when you accept
them, you accept the regulatory burden
that goes with them,” says Mr Olson.
In one area of proportionality, the EU
might be ahead of the US. Mr Cole says
bank start-ups in the US now number
just two per year, compared with 120 per
year before the financial crisis. US community banks are apparently encouraging
the federal authorities to look closely at
the joint start-up unit announced by the
Bank of England and UK Financial Conduct
Authority in January 2016 to “assist new
banks to enter the market and through the
early days of authorisation.”
“There are two separate issues, and
this unit will need to combine them both
through the filter of proportionality:
first, what can be done to simplify the
bank licensing process; and secondly, what
steps can be taken to allow challenger
banks to operate efficiently,” says Mr
Ardalan. GRR
5
Global Risk Regulator
Basel credit rules grapple
with national differencess
from page 1
additional risk sensitivity. At the same
time, we tried to avoid undue complexity. In choosing a way forward for the revised approach, I expect the Committee
will follow the path of simplification
rather than increasing complexity,” said
Mr Ingves.
The most high-profile aspect of this
trade-off was the debate over the use
of external credit ratings in the standardised approach. During the financial
crisis, these proved inaccurate for US
sub-prime structured finance instruments and some banks, although corporate and sovereign ratings have generally performed well. In response to the
crisis, the US government removed external ratings altogether from its regulatory capital framework. The December
2014 BCBS consultation proposed doing
the same, adopting instead two key risk
Ulrik Nodgaard
“From our
perspective, it
makes sense
to bring back
external credit
ratings”
drivers for each corporate exposure –
revenues and leverage.
As flagged by Mr Ingves in October,
the BCBS changed course in a second
consultation published in December
2015. This consultation reintroduced
external ratings with “alternative approaches for jurisdictions that do not allow the use of external ratings for regulatory purposes”. Banks will be required
to add an extra layer of due diligence
to ensure that external ratings are accurate. This extra safeguard could result in
risk weights being increased “if the due
diligence assessment reflects higher risk
characteristics than that implied by the
external rating,” but never decreased.
“From our perspective, it makes
sense to bring back external credit ratings. There was a fair attempt to create
a risk-sensitive system using a few basic numbers, but just looking at revenue
6
and leverage for corporate exposures
was maybe an oversimplification considering the underlying exposures that
banks have, for instance the varying levels of leverage in different sectors,” says
Ulrik Nodgaard, the head of the Danish
Bankers Association who was in charge
of the country’s bank supervisor, the
Financial Services Authority, until 2015.
Ratings debate
For jurisdictions such as the US that do
not allow the use of external ratings, the
BCBS has proposed a straightforward
divide between entities that would be
considered investment grade, and those
below investment grade. The first category would have a minimum risk weight
of 75%, the second would carry a 100%
risk weight, along with unrated borrowers in jurisdictions that do allow the use
of external ratings.
Publicly, the credit ratings agencies
welcomed the due diligence component
as an effort to avoid overdependence on
external ratings in capital calculations.
“We support initiatives to reduce
overdependence on ratings in the financial system by removing regulatory
requirements that might trigger mechanistic reliance on ratings,” says a spokesperson for Standard & Poor’s.
This issue poses a dilemma for the
ratings agencies. The use of ratings in
the Basel framework gives them a potential captive market, but it has also led
to a much heavier regulatory burden on
agencies in the wake of the crisis, especially in the EU. In private, none of the
three largest agencies lobbied to reintroduce external ratings to the Basel credit
risk framework, and one lobbied actively
against the idea.
“While Moody’s position has been to
remove ratings from regulation outright,
Basel’s proposal is consistent with the
international community’s agreement to
move away from mechanical use, and toward a broader set of tools that informs
judgments on credit risk calibration,”
says a spokesperson for ratings agency
Moody’s.
Scott Bugie, president of Global
Banking Insight and a former managing
director of financial institutions ratings
at Standard & Poor’s, believes the combination of external ratings and other
methodologies makes most sense. He
suggests that external ratings are most
useful for asset classes with very low
default rates such as sovereign debt. For
other types of loan, he thinks it may be
more useful to employ historic performance inputs as the first determinant of
risk weights.
“Regulators in each country are able
to look through the past few recessions,
say over 25 years, and see the actual
credit losses on bank portfolios. In many
developed countries that would be plenty of data to look at corporate loans by
subsectors and by size. That could then
be compared with the default rate that
external ratings would have predicted,
Scott Bugie
“Regulators in
each country
are able to look
through the past
few recessions,
and see the actual
credit losses on
bank portfolios”
to act as a reality check on inputs that
national regulatory data cannot capture,
for instance on non-domestic lending,”
says Mr Bugie.
He adds that Pillar 2 supervisory
add-ons could then be used to capitalise
other structural risks such as changes in
lending practices or a high proportion of
floating rate loans that leave borrowers
exposed to rate rises.
The BCBS, however, aims to produce
global minimum standards that are suitable for all member states. It is increasingly focused on reducing the variability
of outputs from RWA methods, which
is the motivation for the standardised
floors concept. Global banking organisations such as the Institute of International
Finance (IIF) support the idea of better
RWA comparability that allows banks to
compete cross-border on a level playing field, provided this can be adequately
balanced against risk sensitivity.
“There has to be a balance between
prescription and flexibility, to ensure
there is not too much variability across
jurisdictions, while taking account of underlying credit risk conditions. That is
why it is important to review how the
BCBS is looking at floors for the IRB
approach, because it is internal models
that allow particular credit issues to be
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February 2016
Global Risk Regulator
taken into account so that risk sensitivity is aligned correctly with each bank’s
portfolio,” says Matthew Ekberg, senior
policy adviser on regulatory affairs at the
IIF.
For this reason, he expresses the
hope that the iterative review process
will continue beyond the end of the consultation period on March 11, to ensure
that the calibration of the standardised
approach works appropriately with
any capital floors initiative. Overall, Mr
Ekberg is positive about the reintroduction of credit ratings.
“This is a more measured approach
that will help to balance risk sensitivity
and simplicity, and certainly helps reduce
the variability of risk weightings, which
would have resulted from the risk driver
approach originally envisaged in 2014,”
he says.
buckets, but must instead apply the risk
weight across the whole exposure. The
minimum risk weight would be 25%,
which Mr Nodgaard regards as harsh
given the very low loss experience on
well secured mortgages. The second
question is around the valuation of the
real estate itself. The current consultation holds this fixed at the point of loan
origination.
“We are in favour of allowing the
use of dynamic property prices in assigning LTV ratios, and that is already
standard practice in Denmark,” says Mr
Nodgaard.
Matt Ekberg
“This is a more
measured
approach that will
help to balance
risk sensitivity and
simplicity”
Real estate divides
The choice between national specifics
and global standards is perhaps sharpest
in the category of loans secured by real
estate, for which the BCBS has devised
a separate new methodology in the second consultation. In the first draft, the
risk drivers for RWAs would have been
the loan-to-value (LTV) ratio, and the
debt service coverage (DSC) ratio. The
DSC has now been dropped as a mandatory risk driver, although the BCBS emphasised that it should still be used as a
key underwriting criterion.
According to the second consultation, the reason for the change was that
industry feedback had demonstrated
“the challenges of defining and calibrating a DSC ratio that can be equitably applied across jurisdictions”.
“From a northern European perspective, having low losses on exposures
secured by real estate makes it important to have capital requirements that
reflect those low losses. We could see
the theoretical rationale for bringing in
the debt service coverage ratio requirement, but a one-size-fits-all approach
was not suitable looking at the practical aspects of how it would work across
all jurisdictions worldwide, given differences in tax systems for instance,” says
Mr Nodgaard.
There are a number of areas where
he would still like to see further refinements. First, banks are not allowed to
split the exposures into separate LTV
February 2016
The BCBS has also proposed dividing
real estate secured loans into three categories embracing both retail and commercial property. First, owner-occupier
loans where repayment of the loan is
not dependent on rental streams from
the property; secondly, loans that are
serviced by the cash flows from rental
streams; thirdly, loans for land acquisition and development.
For Mr Bugie, real estate development debt is the distinctive asset class
that needs to be treated quite differently
from mortgages on existing properties.
He suggests subdividing real estate development debt into two further categories: let and unlet properties.
“If tenants have signed long leases before construction, then the credit quality
of the loan really depends on the underlying credit quality of the lessee which
may or may not have an external credit
rating. This granularity of information can
be hard for analysts to find out, but regulators need to know such information because it makes a major difference to the
level of risk,” says Mr Bugie.
Special treatment
Another politically sensitive issue is the
treatment of loans to small and medium
enterprises (SMEs). The BCBS has ruled
the EU to be in material non-compliance
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with Basel standards because of the SME
supporting factor that allows lower risk
weights on SME loans under the capital
requirements regulation.
Most SMEs do not have external
credit ratings, so a general supervisory
minimum risk weight is required. The
BCBS has proposed a level of 85%. Mr
Nodgaard believes this is about right,
although he notes that it is challenging
to define SMEs as an asset class. By contrast, Mr Bugie considers it quite a low
floor.
“SMEs are numerous and economically important, and there has been a lot
of lobbying to keep SME lending affordable, especially in the EU. Regulators have
worked with the numerator of capital
ratios and built up far higher capital at
the banks since the crisis, and that increases the pressure to keep the risk
weights lower,” says Mr Bugie.
There are other elements of the
standardised approach which affect
credit exposures that are a small part
of most banks’ balance sheets, but could
have a large impact on certain business
lines.
“The BCBS has said that it is not
their intention to raise capital requirements overall, but in certain areas we
do see a potential increase. Specifically,
the increase in credit conversion factors
for off-balance-sheet instruments, such
as unconditionally cancellable commitments, goes beyond what was proposed
in 2014,” says Mr Ekberg.
On the positive side, the BCBS also
reviewed the capital requirements for
exposure to collateral in securities lending transactions. These could have been
costly for agency securities lenders affiliated to banks, says Josh Galper, managing principal of securities lending consultancy Finadium.
Most likely, those costs would be
pushed onto prime brokers, and through
them to their hedge fund clients and
end-investors. In the second draft, banks
are permitted to net some non-cash or
non-government bond collateral exposures, allowing more flexibility on what
collateral they can request from clients.
“This change leads to a very important improvement: banks are telling us it
will reduce their credit exposure charge
on securities lending by 60% to 80%,
so this is a meaningful change,” says Mr
Galper. GRR
7
Global Risk Regulator
Market participants seek to revive
single-name CDS
The credit default swap market has suffered years of declining volumes, partly thanks to
regulatory burdens, but dealers are optimistic it can begin to recover. By Michael Watt
In December 2015, 25 leading investment management companies committed to clearing single-name credit default
swaps (CDS). The firms said the initiative
was intended to promote “a robust market place that can be accessed to manage
credit risk” by enhancing the transparency
and efficiency of single-name CDS.
The single-name CDS market currently finds itself afflicted by overlapping factors that have shrunk liquidity and pushed
some market-makers out of the business.
These factors include unfavourable economic conditions, tougher regulations and
uncertainty over new market structures,
to name a few.
Bald statistics tell the story well
enough. In the second half of 2011, according to data gathered by the Bank for
International Settlements, the total global
notional value of single-name CDS contracts stood at $18,100bn (see chart).
By the first half of 2015, this had fallen to
$8200bn. Over the same period, the gross
value of the market fell from $958bn to
$278bn.
As a result, the industry has banded
together to help pick the single-name
market up, dust it off, and get it back to
a healthier state. The International Swaps
and Derivatives Association (ISDA) has
also brought in technical alterations to
CDS trading processes in an attempt to
further boost liquidity.
Cause for optimism
Unlike many financial instruments, singlename CDS remains vital to the safe functioning of the market. While the slow
death of many esoteric types of derivatives has gone largely unmourned, CDS is
seen as worth defending by participants
on the sell-side and buy-side. Users claim
that it remains the best way to hedge
against precise credit risks, and the best
way to express a position on a particular
credit in the market.
“When we talk about liquidity problems in CDS, it is important to remember that we’ve seen lower liquidity across
8
almost every area of trading, not just in
credit. In fact, single-name CDS activity
has held up better than some. We are
seeing strong activity among corporate
names, and in emerging market sovereigns,” says Francois Popon, co-head
of European CDS trading at Société
Générale in London. “Overall, I am very
optimistic for the market.”
This optimism stems from a gradual
change in the economic cycle, with individual, idiosyncratic credit risks likely to
come to the fore. The long period of low
rates and low volatility that set in after
the financial crisis produced a focus on
macro risk, but now that this is coming
to an end, investors should see more defaults, and therefore should have more
reason to take on accurate credit protection. Single-name CDS is still, more than
20 years after the invention of the instrument, the best way to do this. Index CDS,
which generally contain a basket of credit
names from a particular sector or region,
offer a cheaper route to credit protection, but can often be an inefficient hedge
against specific defaults.
“Using CDS indices was very popular
when the market was trading on a macro
basis. Now we are seeing individual credit
stories and concerns coming to the fore,
and using a CDS index in this environment is sometimes not optimal. Singlename costs have increased, but not to
the extent that seeking a perfect hedge
has become economically unviable,” says
James Duffy, head of single-name CDS
trading for Europe, the Middle East and
Africa at Citi in London.
Although overall CDS volumes have
fallen, there can still be enormous activity around specific credit events, proving that the single-name market remains
an attractive prospect at the right times.
The Volkswagen emissions scandal, which
broke in mid-September 2015, illustrates
this perfectly. With the embattled car
company potentially facing a rash of damaging lawsuits as a result of its manipulation of emissions data, market sentiment
towards its creditworthiness took a
battering. According to data supplied
by Markit, the cost of a five-year CDS
on Volkswagen ballooned from 75 basis
points (bps) by close of play on Friday
September 18 to 134bps the following
Monday. It reached a peak of 300bps on
September 29, and had settled to 180bps
by January 14.
“We saw a large uptick in activity in
the week of the Volkswagen scandal last
year. There was a high standard deviation
move in the weekly volume, with more
than $4bn of notional traded,” says Mr
Duffy. “A CDS is a classic bear market
instrument and, with idiosyncratic risk on
the rise, it feels as though CDS volumes
have bottomed out.”
Regulation drag
Bottomed out, perhaps, but unlikely to
recover to the levels seen in years gone
by. The economic cycle might be moving
in the instrument’s favour, but it is still
weighed down by the regulatory changes that have had such a deadening effect
across the derivatives markets. Under the
Basel 2.5 and Basel III reform packages,
banks must hold far more capital against
their derivatives books, thereby raising
costs and reducing the amount of balance
sheet available for market-making.
Basel III’s leverage ratio has also restricted CDS trading. “Under the leverage ratio, there are additional costs related to your full forward notional that apply to credit derivatives but not to other
derivative markets. Under Basel III, banks
also have to hold an increased amount of
capital against counterparty exposures, so
having a large CDS book is heavily penalised,” says Saul Doctor, a credit strategist
at JPMorgan in London.
As a result, buyside participants have
found it more difficult to execute sizeable
CDS deals. “One of the most common
complaints we get from clients is that it is
harder and harder to get a good price on
a single name when the market is quiet.
Before the decline in liquidity set in, you
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February 2016
Global Risk Regulator
NOTIONal aMOUNTS OUTSTaNDING OF SINGlE-NaME CDS ($BN)
20000
15000
$bn
10000
5000
The blame game
February 2016
H1 2015
H2 2014
H1 2014
H2 2013
H1 2013
H2 2012
H1 2012
0
H1 2011
The CDS market has also had to face the
ire of legislators. At the height of the eurozone sovereign debt crisis, embattled
politicians believed that CDS speculation
was reducing the perceived creditworthiness of several peripheral states, and
therefore contributing to higher borrowing costs. In November 2011, the
European Parliament voted to ban ‘naked’
CDS trading – that is, taking on a singlename CDS contract without owning the
underlying bonds of the entity.
Dipping further back into history,
rampant activity in the CDS market is also
blamed for magnifying the losses of many
financial institutions during the 2007-2008
crisis, leading most notoriously to the
near-failure of the insurance giant AIG.
Shaking off these negative attitudes is
part of the reason why central clearing is
deemed to be so important for the CDS
market. The goal of routing all standardised over-the-counter derivatives trades
through central counterparties (CCPs)
was established at the Pittsburgh G20
summit in 2009, but a series of legislative and regulatory delays in the US and
Europe meant that it took some years for
clearing mandates to be attached to various instruments. In Europe, for instance,
CDS clearing for current CCP clearing
members is not expected to begin until the end of 2016 at the earliest, after
which it will be phased in for other types
of counterparties.
Though many in the industry recognise
these changes as fair and necessary from a
risk management standpoint, clearing has
often been viewed as a costly, logistical
burden. “I think we still need to fight a
slightly sceptical attitude toward clearing.
It may result in a bigger initial cash outlay,
but it will definitely improve the overall
health of the CDS market. From an individual trade perspective, clearing is often
H2 2011
could easily execute a $60m CDS on a
high-grade name for 50bps. Now, people
aren’t interested in doing that due to the
effects of higher capital requirements,”
says one credit trader.
“You frequently see clips of between
$50m and $100m going through on specific names if there is some credit event
around that name, but on normal market
days trades of that size are much rarer,”
he adds.
Source: Bank for International Settlements
not optimal, but on a portfolio perspective we can find much greater efficiencies
if we can clear everything,” says Mr Duffy
at Citi.
Opening up
It is hoped that, by making the CDS
market more transparent and less risky,
smaller participants who may currently
prefer safer but less perfect hedges in the
credit futures or CDS index markets will
gravitate towards single names and give
a boost to liquidity and volumes. Even
without the mandates, clearing is imperative from a bank’s perspective. Basel III introduced the credit valuation adjustment
(CVA) charge, an extra amount of capital that must be allocated to a trade to
cover counterparty credit risk. Clearing
mitigates this charge, and without it the
charge can make the capital costs of engaging in derivatives markets too punitive.
Alongside clearing, there have also
been less high-profile, smaller scale improvements to the single-name CDS
market. One such technical fix has been
brought through by ISDA to change the
frequency of CDS ‘rolls’. In a single-name
CDS, the five-year tenor is the most
popular and most liquid. To maintain a
permanent five-year hedge on a particular name, CDS contracts are periodically
rolled forward on to new ‘on the run’
contract dates.
Under the old convention, this happened once per quarter on March 20,
June 20, September 20 and December 20.
This provided a great deal of flexibility,
but also fragmented CDS liquidity across
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these four dates, resulting in a higher
number of different instruments than
was strictly necessary. It could also introduce higher costs. As one credit dealer
explains, rolling a CDS contract may cost
five basis points each quarter, totalling
20bps across the year. For a single-name
CDS book of, say, $100m, that equates
to $200,000 of extra transactional costs
per year.
ISDA’s solution was to reduce the
number of yearly rolls from four to two,
falling in September and March. “The move
to semi-annual rolls isn’t going to result in
a big spike in CDS volumes, but it could
be a useful technical fix that irons out one
of the wrinkles in the market. With more
roll dates you have a greater number of
different contracts, and less ability to focus liquidity. It’s likely that we’ll have to
wait until perhaps this time next year to
feel the full effect of the change from a
liquidity point of view,” says Mr Doctor.
The new mood of optimism for singlename CDS has come too late for some
banks. In 2014, Deutsche Bank announced
that it would pull out of the credit derivatives market in general, and in reality only
a few large banks currently have significant capacity for single-name CDS market
making.
“Banks that have already unwound
their credit businesses may come back
to the market and start afresh when
times are better, but if not there may be
a capacity problem in CDS,” says Kevin
McPartland, head of market structure and
technology at US advisory firm Greenwich
Associates. GRR
9
Global Risk Regulator
Community banks challenge FaSB
to make accounting reform scalable
Community banks are challenging the US accounting standards setter to make
proposed changes to loan loss accounting work for small banks. By Charles Piggott
Compared to the Financial Accounting
Standards Board’s (FASB’s) 2010 proposal
to make fair value the default measurement standard, the US accounting standards setter’s long-awaited January 2016
standards update on fair value accounting may not seem radical. In fact, three of
seven board members voted against the
reforms for not going far enough and for
retaining too heavy an emphasis on amortised cost-based accounting.
But for banks and insurance companies with significant equity holdings and
firms that still rely to some extent on entry prices to base fair value disclosures of
items reported at cost, the changes may
still prove challenging.
Under current US generally agreed accounting principles (GAAP) rules, equity
portfolios can be held as ‘available for sale’
(AFS) with changes in market value recognised in other comprehensive income
Scott
hildenbrand
“I’m not sure
we’re going to get
any information
on which you
could base an
investment”
(OCI) rather than earnings. But from
2018, all fair value changes in public companies’ marketable equity holdings (other
than consolidated investments or those
over which the investor has significant influence) will be recognised in net income.
On top of this, all firms will now have to
rely solely on projected exit prices (rather than entry prices) as the basis for fair
value disclosures of items reported at amortised cost.
Also significant is the fact that the FASB
has ditched with immediate effect the requirement for banks to report debt valuation adjustments (DVA) in profit and loss.
10
Instead, firms will be allowed to strip out
changes in the risk profile of their ‘own
credit’ for instruments they have ‘elected
to measure at fair value’ into OCI where it
will not affect their bottom line.
Shahid Shah, New York-based partner
at Deloitte, says that given analysts already
strip out DVA from banks’ earnings, it is
the FASB’s elimination of the AFS category for equity securities that will have the
biggest impact, particularly for insurance
companies and smaller banks with investments in equity securities. “In these cases
we’ll see more earnings volatility and possibly changes in business strategy as they
switch to holding more debt securities,”
he says.
Earnings volatility
Most large US banks do not hold large
equity portfolios. But for some smaller
banks with a higher proportion of equity
investments, the new requirement will
have more uncertain implications.
Michael Gullette, vice president for accounting and financial management at the
American Bankers Association (ABA) says
there is a handful of small US banks that
due to longstanding agreements with state
regulators hold more significant equity
portfolios. “We’ll be working with regulators and accounting standard setters
over the next three years to figure out
how these 80 or so banks can account for
their equity portfolios. Otherwise, they
may have to rethink their equity holdings
to avoid introducing greater volatility into
their earnings statements.”
Even though many smaller banks have
unrealised gains on their available-for-sale
portfolios, they remain reluctant to book
them either as profit or as increased reserves. “Almost every community bank
I’ve spoken to has opted out of recognising mark-to-market changes in available-for-sale securities in their regulatory
capital,” says Scott Hildenbrand, chief balance sheet strategist at investment bank
Sandler O’Neill. “They don’t want volatility in regulatory capital.”
Some insurance companies may be
similarly affected. Although US insurance
companies rely heavily on bond portfolios rather than equities to match their
liabilities, some have equity portfolios of
between 5% to 10% of their total assets.
“It goes without saying that, upon effective date, accounting for equity investments through earnings will in itself create
earnings volatility,” says a global strategist
for one of the largest insurance companies.
He adds that “the true test” of the
FASB’s financial instruments framework
“will be in how it fits the new insurance
framework still under deliberation” by the
International Accounting Standards Board
(IASB).
Michael Monahan, senior director of
accounting policy at the American Council
of Life Insurers (ACLI) says that the insurance industry generally accepts fair value
accounting, so as long as it applies to both
assets and liabilities equally. “What we’ve
had for a long time is fixed liabilities, but
assets that move up and down in value and
that’s not a true reflection of the industry’s performance. But if both assets and
liabilities are measured at current value
there will be more symmetry, less noneconomic noise and yet true economic
volatility will still come through in the
financial statements. That’s what analysts
want to see. If we get symmetry in the
financial statements, the IASB will have
achieved its goal.”
Both the FASB and IASB have projects
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Michael Gullette
“Figuring out
what community
banks could get
on the street for
a portfolio of
commercial loans
is going to be
difficult and costly”
February 2016
Global Risk Regulator
nearing completion under which insurance
liabilities will have to be carried at more
current valuations. “Both initiatives will
require firms to discount and update interest rate and cash flow estimates on the
liabilities-side regularly,” says former FASB
chairman, Leslie Seidman, now executive
director at the Center for Excellence in
Financial Reporting at Pace University’s
Lubin School of Business.
“This could cause further earnings
volatility, but it could also mitigate the
fact that changes in equity securities will
now be recognised in profit and loss. But
there’s no reason to believe the two will
be correlated.”
expected with regard to needed methods,
processes, data or documentation, as well
as how CECL might be scalable for smaller
banks.”
One of the biggest concerns, says Mr
Gullette, is that US auditors have been
working to get banks to quantify what are
largely qualitative factors. “With the lifeof-loan loss model that’s going to be 10
times more complicated and pulling that
switch [in 2018] is too much for smaller
banks with fewer employees.”
Finding the expertise to project lifeRussell Golden
“The Board will
consider the
comments of
the participants
seeking additional
re-exposure or
other forms of
public comment”
No more entry pricing
Another challenge for small banks from
the FASB’s January 2016 financial instruments update will be the requirement to
disclose fair values for financial instruments carried at amortised cost based on
a notional exit price, thus eliminating the
entry price method currently in use by
many firms.
Ms Seidman says estimating an exit
price for non-marketable loans will typically require some sort of a discounted
cash flow analysis or possibly a matrix approach. “It has to be an estimate of how
a market participant would rate the creditworthiness of these loans, including current interest rate assumptions. The key
will be to keep focused on how a market
participant would view the fair value of
these assets, rather than the value to the
bank itself.”
The FASB argues that investors should
be able to base their analysis on similar
information. But for smaller banks, exit
price valuations may add little benefit,
says the ABA’s Mr Gullette. “Figuring out
what community banks could get on the
street for a portfolio of commercial loans,
each with unique terms, when these don’t
come up for sale is going to be difficult and
costly. We’re more concerned because
analysts pay little attention to these fair
value loan estimates anyway.”
Even more challenging for smaller
banks will be the requirement for life-ofloan current expected credit loss (CECL)
accounting currently due for release in
the first half of 2016. “The CECL model
represents the biggest change – ever –
to bank accounting,” ABA president Rob
Nichols wrote to the FASB on January 13.
“We see no agreement about what will be
February 2016
time expected loan losses may not be
easy. “Community banks have already had
to hire non-producing staff to manage all
the regulatory changes. Now they face a
major accounting rule change,” says Mr
Hildenbrand. “Even given the huge amount
of time, resources and energy needed for
community banks to project lifetime loan
losses, I’m not sure we’re going to get any
information on which you could base an
investment,” he says.
But Ms Seidman says the issue of dayone loss recognition has been overblown.
“Banks already estimate losses in their
loan portfolios. For every category of new
loans banks put on their books each quarter, there is some level of loss being recognised, even on the new loans. But we
don’t think of that as a ‘day-one loss’.”
For Ms Seidman, the most important
point is that banks will no longer be restricted to recognising losses only as
they are incurred, but can instead include
a wider set of current information. “It’s
not much more complicated than what is
actually done by firms in practice today.
Firms will still be able to consider historical losses by type of loan and adjust these
to the extent they feel current conditions
don’t reflect the past.”
The FASB has been at pains to revise
and simplify its forward-looking loss model, working with financial statement preparers in the hope that existing historicalloss-based methodologies can be adapted
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to take account of a wider range of inputs.
On February 4, community bankers,
industry associations, standard setters
and regulators met for an at times heated
roundtable discussion during which participants urged the FASB to release another
exposure draft for consultation, including
clear guidelines on audit expectations and
documentation.
Commenting after the meeting, FASB
chair Russell Golden said: “The Board will
consider the comments of the participants
seeking additional re-exposure or other
forms of public comment.”
DVa lives on
The FASB’s January 2016 accounting
standards update removes with immediate effect the requirement for banks to
include fair value gains or losses related
to their own credit risk in their earnings
statements. Instead, these changes known
as debt valuation adjustments (DVA) will
no longer impact banks’ earnings releases
but instead be presented in OCI.
DVA allowed banks to book huge
profits during and after the crisis, but was
widely questioned by analysts because of
its counterintuitive effect of creating profits for banks due to their deteriorating
creditworthiness.
Explaining the change, the FASB said:
“This amendment excludes from net income gains or losses that the entity may
not realise because those financial liabilities are not usually transferred or settled
at their fair values before maturity.”
“DVA was initially applied to instruments like repos where the related asset
was marked to market, so it made sense
for the repo liability to also be carried at
fair value,” says former FASB chair Leslie
Seidman. “But DVA moved beyond that to
include other liabilities, where any related
assets were not necessarily being marked
to market,” she says. “But analysts weren’t
fooled for a minute. They simply stripped
these adjustments out of earnings.”
However, the DVA change only relates
to specific liabilities elected to be carried
at fair value, not to liabilities where fair
value measurement is mandatory, including derivative liabilities where own credit
changes will still have to be recognised
in earnings statements. “The swings in
DVA seen during the crisis that related to
banks’ derivative liabilities will still appear
in firms’ profit and loss accounts,” says
one US accounting expert. GRR
11
Global Risk Regulator
US regulatory round-up
Two banks settle dark pool
charges
THE Securities and Exchange
Commission (SEC) announced on January
31 that Barclays Capital and Credit
Suisse Securities will pay fines of more
than $150m to settle charges for trading
violations in the dark pool venues they
operate.The following day, the New York
Attorney General’s (NYAG’s) office announced parallel actions against the two
firms. Both firms agreed to settle their
cases.
“These cases are the most recent in a
series of strong SEC enforcement actions
involving dark pools and other alternative
trading systems,” said SEC chair Mary Jo
White.“The SEC will continue to shed
light on dark pools to better protect
investors.”
NYAG Eric Schneiderman said in a
written statement:“We will continue to
take the fight to those who aim to rig the
system and those who look the other
way.”
Barclays admitted wrongdoing and
agreed to pay a $35m fine to the SEC and
a $70m fine to the NYAG, while Credit
Suisse accepted $54.3m in penalties and
other charges to the SEC and a $30m
penalty to the NYAG.“These largest-ever
penalties imposed in SEC cases involving two of the largest alternative trading
systems show that firms pay a steep price
when they mislead subscribers,” said
Andrew Ceresney, director of the SEC’s
Enforcement Division.
Included in the SEC’s order against
Barclays is the charge that it failed to
“continuously police” order flow in its
LX dark pool as promised.“Barclays did
not adequately disclose that it sometimes
overrode Liquidity Profiling by moving
some subscribers from the most aggressive categories to the least aggressive.
The result was that subscribers that
elected to block trading against aggressive
subscribers nonetheless continued to interact with them,” the SEC said.
The SEC also charged that Barclays
misrepresented the type and number of
market data feeds that it used to calculate
the National Best Bid and Offer (NBBO)
in LX. For example, Barclays represented
12
that it “utilise[d] direct feeds from exchanges to deter latency arbitrage” when
in fact Barclays used a combination of
direct data feeds and other, slower feeds
in the dark pool, said the SEC.
“Barclays misrepresented its efforts
to police its dark pool, overrode its surveillance tool, and misled its subscribers
about data feeds at the very time that
data feeds were an intense topic of interest,” said Robert Cohen, co-chief of the
SEC’s Market Abuse Unit.
The SEC’s charges against Credit
Suisse included that it misrepresented its
use of a feature called Alpha Scoring on
its Crossfinder dark pool to identify opportunistic traders and kick them out of
its electronic communications network,
Light Pool.
“In fact,Alpha Scoring was not used
for the first year that Light Pool was operational.Also, a subscriber who scored
‘opportunistic’ could continue to trade
using other system IDs, and direct subscribers were given the opportunity to
resume trading.”
Other SEC charges against Credit
Suisse included that it: accepted, ranked
and executed more than 117m illegal
sub-penny orders; failed to disclose to
all Crossfinder subscribers that their
confidential order information was being
transmitted out of the dark pool to other
Credit Suisse systems; failed to inform
subscribers that its order router systematically prioritised Crossfinder; and failed
to disclose that it operated a technology
called Crosslink that alerted two high frequency trading firms to the existence of
orders that its customers had submitted
for execution.
“These cases mark the first major
victory in the fight to combat fraud in
dark pool trading and bring meaningful
reforms to protect investors from predatory, high-frequency traders,” said Mr
Schneiderman. He personally thanked
the Barclays insiders that “provided valuable assistance” with the investigation
for their service to the people of New
York. “It is critically important that those
with knowledge of fraudulent conduct
continue to contact my office, to share
what they know in confidence.” Mr
Schneiderman also confirmed that his
department has other ongoing investigations into dark pools.
Vote backs muni bonds
hQla status
A bipartisan package of bills on financial regulation passed a House of
Representatives vote on February 1.They
include a bill to allow banks to hold municipal bonds (munis) as part of their minimum high quality liquid assets (HQLA),
If signed into law, the bill would require the Federal Deposit Insurance
Corporation (FDIC), the Federal Reserve
(Fed) and the Office of the Comptroller
of the Currency (OCC) to amend their
liquidity coverage ratio (LCR) rule issued
in September 2014.The LCR requires
banks to hold enough HQLA to sell in
order to cover a month of outflows in
a stress scenario where the bank has no
new sources of funding.
Carolyn Maloney
“The Federal
Reserve has
concluded a
fix is necessary
and there is
strong bipartisan
consensus”
“The president’s policies have delivered the slowest and weakest recovery
in history, so Congress must take action
on every good opportunity to help create
jobs and grow the economy,” said House
Financial Services Committee chairman
Jeb Hensarling in his statement.
Sponsored by Republican Luke Messer
and Democrat Carolyn Maloney, the bill
(HR 2209) aims to encourage investment
in local communities by requiring federal
banking regulators to treat liquid, readily marketable investment grade munis
as high-quality Level 2A assets.The bill
passed the house by a unanimous voice
vote.
Under the original LCR rule issued
by banking regulators, Level 1 assets
(cash and US Treasuries) are counted
toward the HQLA buffer at 100%. Level
globalriskregulator.com
February 2016
Global Risk Regulator
OFR warns of rising
contagion risk and CCP
concentration
THE US Treasury’s Office of Financial
Research (OFR) has warned of the rising risk of financial market contagion and
of the concentration risk as a result of
increased levels of central clearing. In its
2015 annual report to Congress released
on January 27, the OFR said that getting
February 2016
better quality data on central clearing counterparty (CCP) risk would be
among its top priorities in 2016.
“The risk of financial stress being
transmitted across different entities and
markets, known as contagion risk, has
risen since our last annual report.The
driver was volatility in financial markets
in the third quarter of 2015,” said the report. Other risks highlighted include the
“persistent effects of low interest rates”
and “elevated and rising credit risks”.
Although the OFR’s risk model suggests that contagion risk is low, the
report said that:“This risk is difficult
to measure in the absence of financial
stress. In our assessment, contagion risk
is actually higher than current measures
indicate.”
The OFR also said also said that
CCPs represent “a single point of vulnerability for failure” that creates “the
potential for propagation of risks, potentially offsetting the advantage”. However,
it also acknowledged that CCPs can reduce counterparty default risk so long as
CCPs have sufficient resources.
The Financial Stability Oversight
Council (FSOC) has designated five
CCPs as systemically important: CME
Clearing, the Fixed Income Clearing
Corporation, ICE Clear Credit, the
National Securities Clearing Corporation,
and the Options Clearing Corp.“These
five CCPs are connected with G-SIBs
[global systemically important banks] that
serve as settlement banks and where
CCPs and their members deposit funds,
US G-SIBs are also clearing members
of multiple CCPs.A G-SIB default could
cause a CCP default and possibly strain
multiple CCPs at once, a scenario that
current CCP stress tests may fail to capture,” said the OFR.
The OFR’s report also highlights the
risks associated with CCPs’ interconnections with each other, for example
through cross-margining agreements by
which positions are netted across CCPs
to central counterparties overseas and
to CCPs not designated as systemically
important.
The international Financial Stability
Board has also put CCP risk as one of
the most pressing issues on its agenda.
globalriskregulator.com
US government guarantees
61% of financial system
THE Richmond Fed’s annual ‘bailout barometer’ has estimated that 61% of private
financial liabilities in the US financial system
are subject to “explicit or implicit protection from loss” by the federal government.
The research, released on February 3,
warned that this level of protection “may
encourage risk-taking, making financial crises and bailouts more likely.When creditors expect to be protected from losses,
they will overfund risky activities, making
financial crises and bailouts like those that
occurred in 2007-08 more likely.”
BaIlOUT BaROMETER
Estimate by Richmond Fed researchers of the
share of private financial sector liabilities subject
to implicit or explicit government from losses
(data as of December 31,2014)
Implicit
Share of private financial sector liabilities
2A assets, including US agency securities
such as those issued by federal housing
loan guarantee banks Fannie Mae and
Freddie Mac as well as agency-guaranteed
mortgage-backed securities, are subject
to a 15% haircut. Level 2B assets, including
corporate bonds and equities that meet
the rule’s liquidity criteria, are subject to a
50% haircut.
But the banking regulators specifically
excluded state and municipal bonds from
HQLA, even securities that otherwise
meet all the rule’s liquidity criteria.“This
means that even if a municipal bond is
objectively more liquid than a corporate
bond using the LCR’s own liquidity criteria, the rule would still treat the corporate bond as ‘liquid’, but not the municipal
bond — purely because the municipal
bond was issued by a state or municipality, rather than a corporation,” said a
statement by Ms Maloney’s staff.
The Federal Reserve proposed changing the LCR rule in May 2015 to include
some state and municipal bonds in the
LCR.“The OCC, however, still refuses to
amend its LCR rule — which governs all
nationally chartered banks — to allow liquid municipal bonds to count as HQLA,”
said Ms Maloney’s statement.
Speaking before the house, Ms
Maloney described regulators’ decision to exclude investment grade municipal bonds from the liquidity buffer as
“senseless”.
“Municipalities across the country
were being hurt as a result.The Federal
Reserve has concluded a fix is necessary
and there is strong bipartisan consensus
in support of correcting this problem,”
she said, adding that without a fix critical
local projects would lack financing.
Explicit
70
60
50
40
30
20
10
0
1999
2014
Source: Richmond Federal Reserve
The report also said that the extensive safety net necessitated “robust”
supervision of firms that benefit from
perceived government protection.“Over
time, shrinking the financial safety net is
essential to restore market discipline and
achieve financial stability. Doing so requires
credible limits on ad hoc bailouts,” said the
Richmond Fed.“Despite efforts to end ad
hoc bailouts, the financial safety net that
protects certain firms remains large under
current government policies.” The Bailout
Barometer has grown from 45% since its
launch in 1999.
In addition to explicit government
guarantee programmes, the researchers
Liz Marshall, Sabrina Pellerin and John
Walter included implicit protection inferred from past government actions and
statements. GRR
13
Global Risk Regulator
harmonisation is key obstacle to EU
securitisation revival
The European Council has addressed some of the shortfalls in a plan for lower capital
charges on qualifying deals, but originators could face a compliance overload. By Philip
Alexander
Industry participants believe harmonising
rules across EU countries may be the vital
missing piece of a plan to allow preferential
bank capital requirements on qualifying securitisations. The Luxembourg presidency
of the European Council agreed a text before its rotating term ended in December
2015, which modifies proposals from the
European Commission to define simple,
transparent and standardised (STS) securitisations and apply lower risk weights
when they are held on the banking book.
Attention now turns to the European
Parliament, which has appointed separate
rapporteurs on the two aspects of the
process: the definition of STS deals, and
the amendments required to the Capital
Requirements Directive (CRD IV). Paul
Tang, a Dutch member of the European
parliament (MEP) from the largest centreleft grouping, the Social Democrats, is responsible for the STS component. He has
already stated that his priority is to improve small and medium enterprise (SME)
access to finance. Pablo Zalba Bidegain, a
Spanish member of the largest centre-right
group, the European People’s Party (EPP),
will steer the CRD IV component.
“We now have official recognition that
securitisation can be done well, and that
there should be bifurcated regulation if it
is. There is a working definition of qualifying securitisations that is complicated but
on the whole sound. What we did not anticipate when we began these discussions
in 2012 is the amount of time taken – it
looks as if 2018 is the earliest we can expect these rules to be in place,” says Ian
Bell, head of the secretariat at the Prime
Collateralised Securities (PCS) initiative,
which has championed the STS concept.
The Commission text comprises 55
rules that a securitisation must comply with
to be considered STS, as well as referring
to a further 24 rules under Article 5 of the
EU treaties. The Council added another
three rules to the list.
With such a lengthy set of criteria to
meet, the certification process for STS
14
will be vital. In its first consultation of the
European Commission initially proposed
self-certification only. Among the more
than 30 asset managers and industry associations that replied, there was consensus
support for some form of third-party certification, such as the PCS initiative, to ease
the compliance burden on investors.
“The European Commission has spoken of a €500bn market for STS securitisations. That will not be achieved with the
small number of existing investors, but new
Ian Bell
“We now have
official recognition
that securitisation
can be done
well, and that
there should
be bifurcated
regulation if it is”
investors are unlikely to enter if it involves
hiring new compliance staff to check 82
criteria before buying into each individual
deal. It would take a very large investment
in asset-backed securities to justify that
expense, and each fund would run the risk
that other investors reached a different
conclusion about a given transaction’s STS
compliance,” says Mr Bell.
The Commission’s September legislative proposal has allowed the use of third
party certification. But Mr Bell believes it is
still inhibited by the requirement to certify
the overall outcome – that a deal is STS
– rather than demonstrating compliance
in detail through a series of definitions. As
a result, national competent authorities
could reach different conclusions to an issuer or investor as to whether a specific
transaction was indeed STS. Mr Bell provides just one possible source of ambiguity: how to define a homogeneous book of
loans.
“Portfolio managers may take a view
that motorbike loans are different from car
or van loans because of the higher risk of
writing off the vehicle, but that is not the
same as a legal opinion. Similarly, if buy-tolet mortgages are included in a pool with
owner-occupier mortgages, is that still a
homogeneous residential mortgage-backed
security, or not?” says Mr Bell.
The single supervisory mechanism for
banks in the eurozone may simplify the
process of regulatory coordination, but
in some countries, oversight of the STS
scheme will be shared between separate
bank, insurance and securities regulators.
In total there are around 70 different regulators who might be responsible for policing STS designations in the EU. Any firm
found to have falsely certified a securitisation as STS by any of these individual authorities could face penalties of up to 10%
of turnover, with €5m fines for individuals
and potential criminal sanctions. There is
no equivalent punitive element under, for
example, covered bond laws.
In the Commission’s text, the European
Securities and Markets Authority (ESMA)
could impose binding mediation in the event
of any disagreement. But in the Council’s
amendments, ESMA’s role was effectively
pushed back to a third phase, with the national supervisors taking the first decision,
followed by non-binding ESMA mediation
within one month, before ESMA can step in
and impose a binding decision.
“There has to be a single point of interpretation for this regulation. If not, the
STS concept itself will fail, because the asset
class would not exist as a single market as
part of the family of investments proposed
in the capital markets union,” says Mr Bell.
Model choices
The risk of a fragmented (and therefore
dysfunctional) market is also present in
the second part of the framework – the
amendments to CRD IV that will be
steered through parliament by Mr Bidegain
of the EPP. The vital question for originators, who must retain part of the securitisations they arrange, is the non-neutrality
ratio of capital requirements. This means
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February 2016
Global Risk Regulator
the difference between the capital requirements on a securitisation tranche, and
those on the underlying loans if they were
not securitised.
“There are agency and model risks in
the selection of assets for a securitisation
compared with an underlying loan pool. A
conservative non-neutrality ratio might be
1.5 times, which would imply that every
second securitisation doubles the default
risk relative to the loans themselves,” says
Mr Bell.
However, initial assessments of the
European Commission’s proposals suggest
the capital ratios could still be significantly
higher. For banks using the internal ratings
based approach (Sec-IRBA), the minimum
risk weight would fall to 10%, from 15%.
The European Banking Authority estimated that capital requirements overall could
be cut by about a quarter.
For those banks that do not use internal models, the Basel Committee on
Banking Supervision (BCBS) proposes
an external ratings-based approach (SecERBA) and a simplified supervisory formula known as the standardised approach
(Sec-SA). In Europe, however, permission
to use the Sec-IRBA for securitisation
rests with national supervisors, and usually depends on the bank having access to
adequate historical loss data loan-by-loan.
By contrast, the US has allowed banks to
build Sec-IRBA around loss parameters for
the whole pool.
“Only the very largest cross-border
banks in the EU might have the data to operate the Sec-IRBA outside their domestic
markets, and only on pools of loans they
have originated themselves. In practical
terms, it is difficult to see how a bank in
one country will be able to invest using the
Sec-IRBA in a securitisation from another
EU country where it does not originate
loans itself,” says Georges Duponcheele,
head of banking solutions in the securitisation team at BNP Paribas.
Capital punishment
The European Commission has preserved
the Basel hierarchy, which means the first
alternative that EU banks must use is the
Sec-ERBA. By contrast, the US regulators
have abolished the Sec-ERBA altogether.
Moreover, prioritising external ratings appears to cut across the regulatory desire
(reiterated in the STS proposals) to reduce
mechanistic reliance on the ratings agencies. Ratings agency methodologies – and
in particular the use of sovereign ceilings
on securitisation ratings – mean the risk
weights derived from the Sec-ERBA could
have a substantial dispersion.
According to research by BNP Paribas
and William Perraudin of consultancy Risk
Control, the European Banking Authority’s
(EBA) own calculations show that even
with a rescaling of risk weights in the STS
proposal, the Sec-ERBA would lead 25%
of securitisations carrying a non-neutrality
ratio of five times or more. On the other
hand, around 10% would have a non-neutrality ratio of less than one. That means a
more favourable capital treatment than the
underlying loans, which would surely concern regulators. Mr Duponcheele says this
very low risk weight tends to apply to auto
loan securitisations, while deals backed by
SME loans – the category that the capital
markets union is explicitly seeking to boost
– tend to attract the highest charges.
By contrast, using the Sec-IRBA or
Sec-SA gives a much less dispersed range
of risk weights, clustered between 1.5 and
two times non-neutrality. In its September
2015 proposal, the European Commission
opened the door to allowing banks to use
the Sec-SA if the Sec-ERBA “would result in incommensurate regulatory capital
requirements relative to the credit risk
BaNk RISk WEIGhTS ON STS SECURITISaTIONS (PaR WEIGhTED
aVERaGES, %)
Sec-IRBa
Sec-ERBa
Sec-Sa
Senior tranches
- RMBS
10
43
10
- SME
10
44
10
- Other retail
10
19
10
Mezzanine tranches
- RMBS
59
213
101
- SME
68
238
113
- Other retail
27
87
65
Source: BNP Paribas/Risk Control. STS - Simple, transparent and standard. IRBA - Internal ratings-based
approach; ERBA - External ratings-based approach; SA - Standardised approach. RMBS - Residential
mortgage-backed securities; SME - Small and medium enterprises.
February 2016
globalriskregulator.com
embedded in the underlying exposures.”
However, the permission to use the
Sec-SA would rest on the definition of ‘incommensurate’, which would be decided
by national authorities. This potentially acts
as another source of fragmentation. The
sentiment among market participants is
that core eurozone regulators will be unlikely to allow their banks to overlook low
sovereign rating ceilings in the periphery. If
two regulators disagree, the EBA can decide which approach is appropriate.
“This is all good in theory, but banks need
certainty to reopen the market; they would
not want to have to seek authorisation on
every trade to use the Sec-SA instead of the
Sec-ERBA,” says Mr Duponcheele.
The European Council compromise
sought to improve the situation by allowing banks to apply Sec-SA automatically
to all STS senior tranches. However, Mr
Duponcheele sees two difficulties with
this. First, under CRD IV, originators must
retain some of the junior and mezzanine
tranches of a deal, to ensure their interests
are aligned with investors in the rest of the
transaction. Depending on market conditions, originators sometimes retain a lot
more than the legal minimum.
“Other investors in the senior tranche
could benefit from using the SA instead of
the ERBA, but the originator who actually
knows the underlying loans best will face a
capital charge on the mezzanine tranches
that could be around four times higher
than would be implied by the IRBA,” says
Mr Duponcheele.
Secondly, there is a matter of principle at stake. If policymakers acknowledge
that the Sec-ERBA is leading to disproportionately high risk weights, why apply the
exemption only to STS securitisations? Mr
Duponcheele points to a number of relatively low-risk securitisation structures that
are unlikely to qualify as STS. For instance,
those backed by leasing transactions, widely used to finance SMEs in countries such as
Italy, may not qualify because leasing carries
refinancing risks.
“Are we saying that the Italian banking sector must change the whole way
it finances the real economy? If one of
the lessons of the financial crisis was to
avoid over-reliance on external credit
ratings, then this should be applied to
all transactions, starting with all tranches of STS transactions and the senior
tranche of non-STS transactions,” says Mr
Duponcheele. GRR
15
Global Risk Regulator
Banks still question new
trading book rules
Although the Basel Committee has sought to pare back the capital impact of the fundamental
review of the trading book, specific asset classes could suffer. By Philip Alexander
The largest dealing banks are planning
their own impact study on the final fundamental review of the trading book (FRTB)
to add detail to the broad analysis published by regulators. The Basel Committee
on Banking Supervision (BCBS) published
the final rules that will determine market
risk-weighted assets in January 2016. The
last round of changes mostly involved the
calibration rather than the design itself,
backed up with the publication of select
results from a 2015 quantitative impact
study.
“The data provided did not necessarily support granular analysis of the outcomes of the changes to items such as the
residual risk add-on or non-modellable
risk factors, which had caused concern in
earlier drafts. We believe that the BCBS
will be using a later review with mid2016 numbers to calibrate standardised
floors for the internal model approach,
and banks want to assess the data themselves to be able to feed back into that
process,” says Jouni Aaltonen, a director
in the prudential regulation division of
the Association for Financial Markets in
Europe (AFME).
Earlier studies by the industry suggested that add-ons for residual risk in the
standardised sensitivities-based approach
(SBA) and for non-modellable risk in the
advanced internal modelled approach
(IMA) could both have punitive effects on
the overall capital requirement for market
risk. Moreover, by definition these addons are not risk-sensitive. Aligning capital
more closely to risk was a stated objective
of the FRTB.
On both issues, the BCBS appeared to
soften its stance in the final draft. The residual risk add-on, previously set at 1% of
gross notional amounts, has been cut to
0.1% for those instruments bearing residual risk that are deemed not to be exotic.
It will remain at 1% for exotic positions.
“The final text does not say definitively
what constitutes an exotic derivative, so
there is some confusion, and there will
need to be some clarification, perhaps
16
from each local regulator, over the coming months,” says Ram Ananth, head of
the quantitative practice at financial risk
management consultancy Avantage Reply
in London.
For non-modellable risks, Mr Aaltonen
says the BCBS decision in the final draft
that banks can assume zero correlation
between credit spread risks is an improvement and is in line with industry
practices.
Work in progress
The revised market risk framework will
enter force at the start of 2019. Even with
the latest publication, however, the FRTB
is not complete. The January 2016 paper
has left room for a number of further elements to be fitted into the market risk
framework. First, the BCBS is reviewing
possible exemptions for market-makers
from capital deductions for holding other
banks’ capital securities. In particular, an
initial BCBS paper on total loss absorbing
capacity (TLAC) in November 2015 proposed that any holdings of another bank’s
TLAC equivalent to more than 10% of a
Jouni aaltonen
“Although
they have been
reduced in the
final version, the
market risk capital
charges for some
securitisations are
still punitive”
bank’s equity should be deducted from its
own capital ratio.
Other elements under review include
a preferential market risk treatment of securitisations classified as simple, transparent and comparable (STC), the treatment
of sovereign risk, and the linkage between
the FRTB and credit valuation adjustments
(CVA) for counterparty risk on derivative
positions. The STC initiative will complement moves already under way to reduce
risk weights on qualifying securitisation
tranches held on the banking book (see
pp. 14-15).
“Although they have been reduced in
the final version, the market risk capital
charges for some securitisations are still
punitive and the impact on dealer banks
active in this market is likely to be higher
than the mean capital increase of 22% indicates. The STC proposal will help, but
there are pockets of important securitisation activity that may not qualify for one
reason or another, and market-making in
those transactions will be heavily penalised,” says Mr Aaltonen.
Mr Ananth says a new CVA framework on which the BCBS consulted last
July could interact specifically with the
non-modellable risk factors in the FRTB.
“That could be important, especially
for the treatment of proxy credit spreads
in the CVA capital calculation for counterparties that do not have available
market-derived credit spreads. Banks
will need more work to determine how
the final rules impact overall capital requirements,” says Mr Ananth, a former
market and CVA risk business analyst at
Nomura.
The latest FRTB also excluded the
important question of how the revised
market risk rules will be fitted into Pillar
3 public financial reporting requirements
for banks. The BCBS plans to begin consulting on this topic later in 2016.
“The new framework focuses on tail
risk and extreme events, for instance the
replacement of value-at-risk with expected shortfall models. There will need to
be some careful thought on the granularity of financial reporting to the investor
community on those aspects,” says Mr
Ananth.
The industry has broadly welcomed
the gradual and responsive approach
taken by the BCBS. AFME and two other
industry associations published a short
general response that commended the
“commitment to review the rules over
time, incorporating outputs from other
important regulatory initiatives, such
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February 2016
Global Risk Regulator
as treatment of sovereigns and [STC]
securitisations”.
Sting in the tail
Some developments in the final draft of
FRTB were much less welcome, however. Top of that list was a minimum 1.5
times multiplier to turn the risk-weighted
asset (RWA) calculations into capital requirements. Local regulators can choose
a higher multiplier if they consider it
appropriate.
Market participants believe this multiplier was not added by the BCBS itself,
but by its oversight body, the group of
central bank governors and heads of supervision. Hence it arguably has no quantitative basis, but is instead a large extra
safety margin thrown in at the very last
stage.
Overall, the BCBS impact study suggested a weighted average 40% rise in the
capital requirements for market risk using
internal models. Based on the mean, the
SBA would produce capital requirements
around 1.4 times higher than the IMA, but
the numbers vary significantly across risk
classes. Market RWAs would rise to 10%
of total RWAs, from 6% at present.
“If you look into the details of the
impact study, the capital requirement
from the SBA is three times higher than
the IMA at the 75th percentile. Our own
work on the numbers earlier in the process suggested that the aggregate impact
is closer to the 75th percentile than to
the mean, because the larger capital markets institutions will see more significant
increases in capital requirements depending on the asset classes in which they are
active,” says Mr Aaltonen.
This will have knock-on implications
for the BCBS plan to use standardised
approaches as a floor for internal models. And the rise in total RWAs will also
feed through into the TLAC requirement,
which is calculated as a proportion of
RWAs.
“Market RWAs may remain a relatively small part of those banks’ total balance
sheets, but the implications for activity in
the capital markets themselves are more
significant,” adds Mr Aaltonen.
Those implications will be uneven,
due to some other late changes to the
calibrations. One crucial area of concern
with earlier drafts was the use of liquidity
horizons for internal models – differing
lengths of time that banks must assume
February 2016
would be required to sell down each asset class. Longer liquidity horizons lead
to heavier capital requirements. Market
participants were concerned about procyclical cliff effects because the liquidity
horizon jumped from 20 days to 60 days
if a sovereign bond were downgraded below investment grade. The high yield sovereign liquidity horizon has now been cut
to 40 days, and horizons have also been
eased for a number of other exposures
including high yield corporate bonds and
small cap equities.
Ram ananth
“Cross-border
investment banks
will need to
get each desk
approved globally”
“These are all positive measures
for trading in emerging market assets,
and should also be important for the
European capital markets union project
that is intended to treat small caps more
favourably,” says Mr Aaltonen.
By contrast, in the SBA, the BCBS substantially scaled up the shock assumptions
that must be applied to foreign exchange
(FX) and interest rate risks. Market participants understand that the change to
FX methodology was designed to incorporate the risk of a previously pegged
currency being floated. A number of major FX dealers suffered significant losses
when Switzerland allowed the Swiss franc
to float in January 2015, leading to a 15%
appreciation in just one day. However,
the larger shock to interest rate assumptions has not been explained, and came as
a major negative surprise.
Other hard-hit asset classes are less
controversial. In particular, correlation
trading instruments such as exotic collateralised debt obligations face liquidity
horizons of 60 to 120 days. Such instruments were particularly hard hit during
the financial crisis, and their use by investment banks has declined significantly.
Drawing boundaries
As FRTB moves to the implementation
phase over the next three years, the
quantitative impact studies mean most
large dealing banks have already prepared
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for the major changes in model methodology, such as the adoption of expected
shortfall. The more challenging aspects
will relate to supervisory sign-off on decisions taken by the bank.
One of those will be the boundary
between banking and trading book assets.
The BCBS has sought to eliminate opportunities for capital arbitrage by moving assets between the two books, but
the allocation of positions is not always
straightforward.
“Banks often sell mortgage products
with interest rate or other derivatives
embedded, for instance to manage and
hedge out prepayment risk. The embedded derivatives could go on either side
of the boundary, so banks will need local
regulatory guidance to choose which path
to follow,” says Mr Ananth.
Another crucial innovation is the identification of separate trading desks, each
of which must seek approval to use the
IMA individually. Previously, IMA approval
occurred at the level of the bank’s legal
entity running the trading activities.
This desk-level approval provides
the option for regulators to reject one
desk’s internal models and return it to
the SBA. The BCBS plans to conduct a
further quantitative assessment of IMA
profit and loss (P&L) attribution later in
2016, which will intensify the scrutiny of
whether banks are capturing all risk factors sufficiently in their internal models
for each desk.
“This will calibrate the P&L attribution
test to a meaningful level. Appropriate
calibration is important for this supervisory tool to ensure the robustness of
banks’ internal models at the trading desk
level,” the BCBS noted.
Mr Ananth says the division of market
risk into separate trading desks could be a
“massive challenge” for many banks. “The
banks will need to go through internal
processes, and cross-border investment
banks will need to get each desk approved
globally,” he says.
However, for those banks subject to
the US Volcker Rule that prohibits proprietary trading by institutions benefitting
from federal deposit insurance, their US
operations will already have defined individual trading desks in order to prove
each desk does not engage in proprietary
trading. The banks should be able to apply those processes to help comply with
FRTB desk-level approvals. GRR
17
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Newsroom
Fund manager alarm at
planned liquidity rules
INDUSTRY bodies representing US
investment funds have reacted with
alarm to proposals by the Securities and
Exchange Commission (SEC) for tighter
regulation of liquidity management by
fund managers.The SEC published a
proposal on open-end fund liquidity
risk management and swing pricing in
September 2015, with a deadline for comments in January 2016.
“We support the Commission’s goal
of strengthening liquidity risk management by open-end funds, particularly
among funds that may to date have dedicated fewer resources to managing liquidity risk in a formalised way.While
we support the Commission’s goals, we
believe that these goals would be better
served by a more flexible and less prescriptive approach,” said Tim Cameron,
head of the asset management group
at the Securities Industry and Financial
Markets Association (Sifma AMG), which
represents fund managers responsible
for more than $30,000bn assets under
management.
In particular, Mr Cameron expressed
concern about the SEC’s plan to classify
all assets in one of six liquidity categories
based on time required to convert them
to cash (one business day, two to three
business days, four to seven calendar
days, eight to 15 calendar days, 16 to 30
days and 30-plus days). Funds would have
to hold a minimum level of assets in the
three-day category or more liquid.They
would also be limited from holding more
than 15% of assets in the eight days and
less liquid categories.
“The six-category ‘days-to-cash’
classification system proposed by the
Commission seeks to impose a level of
precision and granularity that is inherently
incompatible with the nature of liquidity
determinations in diverse markets,” said
Mr Cameron.
He warned that the proposed system
is unprecedented, and thus untested.
The data produced would convey “a false
sense of exactitude and comparability,
rather than information that is meaningful to understanding or managing liquidity
18
risk”. Moreover, its implementation would
require massive initial and ongoing
resources, at the expense of proven
liquidity classification and management
processes already in place at many investment funds.
This stance was supported by the
Investment Company Institute, which also
warned that the rules could create precisely the kind of concentration risks and
firesales that the SEC is seeking to avoid.
Investors would crowd out of assets that
might breach the three-day liquid asset
requirement, and into cash, in the event
of market stress, thereby exacerbating
illiquidity.
Tim Cameron
“While we support
the Commission’s
goals, we believe
that these goals
would be better
served by a more
flexible approach”
Mr Cameron is proposing an alternative solution, in which assets would be
divided into four categories.The first are
highly liquid assets that should meet the
purposes of the SEC’s proposed buffer.
The second are assets that are normally
liquid, but may become less so in stressed
conditions.The third are less liquid still,
while the fourth category would be any
assets normally requiring more than
seven days to liquidate, which Sifma AMG
classes simply as illiquid.
Mr Cameron wants fund manager
boards to decide whether it is appropriate to set a highly liquid asset target for a
given fund, based on its liquidity risk profile.A fund manager would have to explain
to the board if the share of liquid assets
dropped below this target. However, to
avoid the risk of stoking investor redemptions, the target or even its existence
should not be publicly disclosed. Sifma
AMG also wants an exemption for new
entrants to the funds market.
On the swing pricing aspect of the
SEC’s proposals, Mr Cameron submitted
a separate, more positive letter.
“We support the concept of swing
pricing as a potential tool that mutual
funds may use to mitigate potential dilution by passing on purchase and redemption costs to the transacting shareholders,
rather than having those costs borne by
remaining shareholders,” he said.
However, he urged the SEC to ensure
that fund managers have indemnity from
any potential legal action from investors over the introduction of this tool.
Moreover, Mr Cameron called for the
SEC to tackle the practical difficulties of
the US fund reporting system in order to
facilitate swing pricing.
“Unlike in Europe, most funds in the
US must calculate and disseminate NAV
[net asset values] at a time before they
have received fund flow information from
most distribution channels.Accordingly,
most US funds will not, even based on
reasonable inquiry, have sufficient information about fund flows at the time NAV
is struck to determine whether the swing
threshold has been breached and thus
NAV should be adjusted,” he said.
Mr Cameron also asked for a oneyear delay between the introduction of
swing pricing and its entry into full operation.This would avoid undue advantage
being given to fund managers in the US
that have experience of operating the
tool in Europe. Regulator and industry
focus on mutual fund liquidity has intensified since a dispute between the SEC
and bond fund manager Third Avenue
in December 2015.The fund manager
decided to shift assets from its $800m
high yield bond fund into a liquidating
trust and suspend redemptions.The SEC
eventually permitted Third Avenue to
keep redemptions on hold while it liquidated the bonds, on condition that the
manager would move assets back into the
main fund and provide daily NAV data to
investors.
EU urged to expand net
stable funding ratio
SWEDISH central bank governor Stefan
Ingves has encouraged EU regulators
to expand the remit of the net stable
funding ratio (NSFR), a key regulation
governing bank liquidity and one of the
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February 2016
Global Risk Regulator
few remaining pieces of the Basel III
framework still to be implemented. Mr
Ingves wrote to the European Banking
Authority (EBA) in his capacity as chairman of the advisory technical committee
at the European Systemic Risk Board. His
letter was designed to feed into the EBA’s
advice to the European Commission on
NSFR implementation. However, his views
carry additional weight because he also
chairs the Basel Committee on Banking
Supervision (BCBS), which designed the
NSFR.
“It is of the essence that the guidance
set by the BCBS is followed. Otherwise,
departing from a globally-agreed methodology would have undesired and unknown
effects for the EU banking system, in
terms of incentives and systemic liquidity
risk,” Mr Ingves warned.
The European Commission had earlier suggested that the EBA examine the
possibility of different NSFR calibrations
for different institutions, based on criteria
such as their business models and risk
profiles.The EBA was called on to consider “the costs and benefits of fully excluding some types of credit institutions from
the scope of application”.
Mr Ingves sought to refute the criticism that the NSFR could lead to concentration in asset portfolios requiring lower
stable funding, or could harm certain
activities especially in financial markets.
He said such claims “fail to grasp the essence of the NSFR requirement”, which
is aimed at limiting maturity and liquidity
mismatches between assets and liabilities.
Indeed, some members of the ESRB
advocated expanding the role of the
NSFR to act as a macroprudential tool
discouraging cyclical increases in liquidity mismatches. Mr Ingves therefore
proposed a “time-varying requirement”
under which a buffer would be added
to the NSFR at times when banks were
taking on additional liquidity risk.The requirement could then be eased at times
of liquidity stress. In parallel, Mr Ingves
mooted varying the NSFR by institution, to impose a higher requirement on
those banks that contributed most to
systemic liquidity risk – a similar concept
to the Basel capital buffer for systemic
institutions.
February 2016
The concept of a variable charge for
liquidity risk was written into the capital
requirements directive by a European
Parliament amendment, having been
proposed to members by Enrico Perotti,
professor of international finance at the
University of Amsterdam. However, this is
the first time that a European regulator
has actively supported such a tool.
“The amendment allows microprudential regulators to ramp up charges on
the difference between liquidity norms
Enrico Perotti
“This is not so
much a charge on
excess illiquidity,
but rather a
charge to reflect
the liquidity risk
being created for
the system”
set by law and the actual level in the
banks.This is not so much a charge on
excess illiquidity, but rather a charge to
reflect the liquidity risk being created for
the system, to induce banks to internalise the cost of liquidity mismatch. Some
national authorities did not like the idea
at all, and the banks were in general even
more hostile,” says Mr Perotti.
Mr Ingves also advised the EBA to
consider applying the NSFR to individual
legal entities as well as at the consolidated group level. He acknowledged that
this goes beyond the BCBS standard, and
would make it difficult to take account of
banking groups that manage liquidity in
a single centralised entity. However, individual national supervisors might need to
be able to react to liquidity conditions in
the subsidiaries of cross-border banking
groups present in their jurisdiction.
“Imposing a requirement on a solo
basis could hamper the free movements
of funds within the EU, but may be justified from a prudential perspective given
the incompleteness of banking union,”
said Mr Ingves.
To accommodate centralised liquidity
management, he suggested some form
of preferential required stable funding
rates on intra-group exposures. Finally, Mr
Ingves said a majority of ESRB members
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strongly supported banks breaking down
their reporting of the NSFR into significant currencies, in line with the BCBS
requirements for the other key liquidity
rule, the liquidity coverage ratio.
US living wills prompt
funding questions
THE US Federal Reserve has released
public sections of more than 120 firms’
year-end 2015 resolution plans, including
three non-bank financial companies designated as systemically important by the
Financial Stability Oversight Committee
(FSOC).
In a bid to convince regulators of its
own resolvability without government
handouts or systemic disruption,AIG
more than doubled the length of its public resolution plan from just 16 pages in
July 2014 to 43 pages in its latest filing.
AIG also outlined how its balance
sheet and legal structure have been scaled
back. Since 2007,AIG has reduced its
total assets by 53%, total debt by 83%
and its debt-to-equity ratio by 83%. It
has also cut the number of legal entities
by 48% and operating entities by 75%.
Furthermore, its reliance on short-term
funding has also been slashed, with securities lending liabilities cut by 99% and its
use of repurchase agreements by 88%.
AIG has also eliminated all use of commercial paper.
Under its preferred resolution,AIG
would see businesses either liquidated or
sold off.Where possible, some businesses
would be restructured and remain operational to save jobs and minimise systemic
disruption. But AIG’s parent company and
some of its non-insurance operations
would be liquidated under Chapter 11
bankruptcy laws.
Prudential Financial said its preferred
resolution strategy would also be reorganisation under Chapter 11 bankruptcy
proceedings, with its US insurance companies undergoing rehabilitation under
the supervision of state insurance supervisors. Prudential Global Funding, which
incorporates the firm’s main derivatives
activities, would be liquidated under
Chapter 11 while Prudential’s asset
19
Global Risk Regulator
Newsroom
management company is likely to be sold
off to raise money.
Prudential’s resolution plan also outlines its use of inter-affiliate funding and
guarantees and other interconnections
between its key legal entities.
Meanwhile, GE Capital said that the
merger and major restructuring announced by its parent company General
Electric would reduce both the likelihood
and complexity of a resolution situation.
General Electric’s ‘GE Capital Exit Plan’,
initiated in April 2015, will see the company largely quit financial services as it
sells off most of GE Capital’s assets and
substantially reduces the company’s reliance on short-term wholesale funding.
According to GE Capital’s resolution plan:“As of December 18, 2015,
approximately $252bn of the $310bn, or
approximately 81%, of total planned dispositions have been closed or signed. Of
the remaining assets and platforms to be
andrea Enria
“Our aim is to
define a common
methodology to
allow readers
to compare and
contrast banks
across the EU on
the same basis”
divested, approximately $58bn, or 100%,
of these assets are actively being marketed, have bids, or have bankers retained
as of December 18, 2015.”
MetLife, which was designated as
a SIFI in December 2014, will have to
submit its first living will by the end of
2016. MetLife announced last month that
it was also spinning out and separately
listing large parts of its US life insurance
business in a bid to ease its regulatory
burden.
However, pro-reformers including
Massachusetts’ vocal senator Elizabeth
Warren have put pressure on bank regulators to take firmer action against firms
that fail to produce credible living wills.
In January, financial reform group Better
Markets called on regulators to: clarify
the criteria used to judge the credibility
of living wills; increase public disclosure
20
of the private section of firms’ living wills;
seek more input from creditors and potential funding sources; and create advisory committees consisting of bankruptcy
scholars, lawyers and judges.
Better Markets is pushing for a requirement that firms disclose publicly
both the amount and source of all financing necessary to execute their resolution
plans. Citing a JPMorgan estimate that it
would take $200bn in funding for the firm
itself to be resolved under the Federal
Deposit Insurance Corporation’s Orderly
Liquidation Authority, Better Markets said
the issue of funding “raises serious doubt
about the credibility of the living wills that
have been submitted”.
Transparency key to EU
stress test
THE European Banking Authority’s (EBA)
2016 stress test, to be launched in late
February, will focus on enhancing the
transparency of bank balance sheets, after
removing the pass/fail threshold used
in previous tests. EBA chairman Anrea
Enria expects the adverse scenario to be
similar to those used in the latest UK and
US stress tests, featuring the impact on
the European economy of a spike in bond
yields and an economic slowdown in
emerging markets, especially Asia.
“We are reshaping the whole framework and moving to an input into the
supervisory assessment to be done by
national supervisors in the second part
of 2016. Our aim is to define a common
methodology to allow readers to compare and contrast banks across the EU on
the same basis,” said Mr Enria, speaking
on the sidelines of a conference to celebrate the fifth anniversary of the EBA.
Both the EBA and the eurozone’s
single supervisory mechanism (SSM) have
in recent weeks emphasised the need for
greater clarity on bank balance sheets,
and in particular on the capital add-ons
applied by supervisors under Pillar 2 of
the capital requirements directive (CRD
IV).The EBA issued an opinion calling for
greater certainty and consistency on any
restrictions to bank pay-outs to investors
– the so-called maximum distributable
amount (MDA). Supervisors have the
power to limit dividend payments and
subordinated bond coupons to investors,
and variable remuneration to executives,
if bank capital needs restoring.The EBA
opinion underlined that the threshold for
MDA calculations should include both
Pillar 1 and Pillar 2 capital requirements.
“The push for increased transparency
reflects our belief that if investors are to
bear the costs of bank failures, they need
to have access to all relevant information,” Mr Enria said when the MDA opinion was published.
The SSM published a statement saying that it planned to implement the EBA
opinion on MDA.The eurozone supervisor noted that capital requirements
for EU banks in 2016 would increase
by around 50 basis points as CRD IV
is phased in, of which 30 basis points
will be accounted for by the Pillar 2
requirements.
A number of the largest European
banks including Deutsche Bank and BNP
Paribas were obliged to issue statements
in late 2015 or early 2016 reassuring investors of their ability to make dividend
and alternative Tier 1 (AT1) coupon payments.This came amid heightened market
volatility for AT1 and contingent convertible (CoCo) bonds in particular, as investors fretted about possible write-downs
or restrictions on coupons where banks
are too close to their minimum capital
requirements.
“We will avoid buying debt of banks
that are in troubled zones or that have
questionable business models.We are a bit
more cautious on the new CoCos, choosing only the best franchises and limiting
our exposure,” said Anthony Smouha,
credit strategies portfolio manager at
Swiss asset manager GAM, in a written
comment on investment strategy.
Fed hikes credit losses in
2016 stress test scenarios
THE US Federal Reserve has released largely tougher scenarios for this year’s supervisory stress tests. On January 28, the Fed
released severely adverse scenarios that
include a severe global recession, 10% US
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February 2016
Global Risk Regulator
unemployment, a period of heightened corporate financial stress and negative yields
for short-term US Treasury securities.
“It is important that the tests not be
too predictable from year to year,” commented Fed governor Daniel Tarullo.
Compared to 2015, this year’s severely
adverse scenario includes: a larger widening
in credit spreads for municipal, sovereign,
and advanced economies’ corporate products; greater declines in private equity investments, recently issued securitised products,
and non-agency residential mortgage-backed
securities (MBS); a more severe widening in
basis spreads between closely related assets
such as government agency MBS and ‘to-beannounced’ forwards as well as corporate
bonds and credit default swaps; and negative
short-term US interest rates.
The Fed said that “these differences are
intended to reflect the result of a more significant drop in liquidity than was assumed
in the 2015 severely adverse scenario and
would be expected to result in notably
higher losses on more illiquid assets.”
Banks must submit their capital plans
and stress testing results to the Fed before
April 5, 2016, with results due out before
June 30, 2016.
EU promises proportionate
stance
LorD Jonathan Hill, the European
Commissioner for financial services, has
pledged to ensure proportionality in the
EU’s application of new bank rules originating from the Basel Committee on Banking
Supervision and the Financial Stability
Board (FSB).The Commission is due to
consider how to implement the Basel
leverage ratio and net stable funding ratio
(NSFr) in 2016, and will also examine how
to introduce the FSB’s total loss-absorbing
capacity (TLAC) designed to facilitate the
resolution of systemic banks.
“Part of good law making is that you
have rules that command respect.That
means they need to be proportionate,
related to risk, and drawn up in way that
reflects different business models and sizes.
And in striving for financial stability, we also
need to remember that lack of growth is
one of the biggest threats we now face to
February 2016
financial stability. So I want us to apply rules
in a way that takes account of their implications for European businesses.That’s the
approach to legislation we will be bringing
forward this year to implement the TLAC
requirement.And that’s also how I’ll be approaching issues like the NSFR, and on the
leverage ratio,” said Mr Hill.
Daniel Tarullo
“It is important
that the tests not
be too predictable
from year to year”
Smaller European banks have been calling for a lower reporting burden on key
Basel ratios (see cover story).This stance
has now won support from the European
Banking Authority (EBA).
Speaking at a fifth anniversary conference for the EBA, Mr Hill also said he
wanted “a period of greater regulatory stability” after implementing the final elements
of Basel III.
“This approach fits into the
Commission’s broader objective of regulating better and regulating less.This year we
will proposed 80% fewer laws than was
usual each year under the last Commission.
And we’re reviewing two and half times
as much legislation as in previous years to
check whether it is working as intended,”
Mr Hill pledged.
Pressure grows on leverage
ratio
THE Basel Committee on Banking
Supervision (BCBS) is facing increased
pressure to exclude client clearing collateral from its calculation of the leverage
ratio.The BCBS is reviewing and calibrating the leverage ratio this year, and industry associations have repeatedly criticised
this aspect of the current rules. Legally,
collateral posted with bank dealers for
cleared derivative trades is segregated
from the bank’s own assets. Consequently,
bankers have long argued that it should
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not be counted toward total assets in
the unweighted leverage ratio of capital
to assets. Instead, initial margin posted by
clients should be used to offset the bank’s
exposure numbers.
The Bank of England has now backed
this stance in an official response to a consultation by the European Commission that
closed in January 2016.The Commission
had invited input on the cumulative impact
of financial regulation since the crisis, and
specifically on any rules that were contradictory or incoherent.The G20 nations
have strongly supported central clearing
of derivatives as a way to reduce potential
contagion between derivative counterparties if a large derivative trader such as a
bank dealer fails.
“Access to central clearing depends on
the willingness of banks to act as clearing
members.There is a risk that more banks
will exit the client clearing market because
they do not believe they can generate an
economic return on capital, leading to concentration of activity on a few providers.
The Bank therefore thinks that the leverage treatment of derivatives exposures for
centrally-cleared client transactions within
the leverage ratio exposure measure needs
to be reviewed.The Bank supports allowing client initial margin to offset potential
future exposure on centrally-cleared client
transactions when calculating the leverage
exposure measure,” the Bank of England
said in its consultation response.
Just days earlier, the US Securities
Industry and Financial Markets Association
asset management group (Sifma AMG) had
written to the BCBS on the same subject.
The Sifma AMG had surveyed its members,
and found that 60% had been made to pay
higher clearing fees for interest rate swaps
over the past two years.Around half had
been asked by an individual clearing firm to
cap the notional amount of swaps cleared
with that firm, and 30% had been forced to
terminate services with a clearing firm and
seek alternative providers.
“Sifma AMG members believe that the
failure to recognise the exposure-reducing
effect of segregated initial margin in cleared
derivatives transactions makes clearing
banks’ leverage ratio requirements needlessly higher than they should be,” the letter concluded. GRR
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Global Risk Regulator
EU wades into insurance
systemic risk debate
The European Systemic Risk Board has proposed countercyclical rules to avoid firesales by
distressed insurers and a build-up of systemic risk. By Philip Alexander
The European insurance industry has just
implemented the vast Solvency II risk-based
capital regime at the start of 2016, but some
regulators are already pushing for more.
In a report issued in December 2015, the
European Systemic Risk Board (ESRB) noted that Solvency II will increase capital and
reserving requirements among EU insurers. But the ESRB added that the new rules
might also introduce new risks.
“Many national supervisors currently
have powers, tools and flexibility which can
help limit risks to financial stability and have
actually used these in the past decade. Some
of these tools will still be fully applicable under Solvency II, some will be institutionalised
in Solvency II but with much less flexibility,
and others will not be available anymore,”
said the report.
In particular, the ESRB considered the
need for tools to address macroprudential
risks across the insurance sector as a whole,
and the danger of procyclicality. In theory,
Solvency II includes a long-term guarantee
package such as the volatility adjustment,
designed to reduce reserving requirements
at a time when insurance capital is under
pressure, to avoid firesales of riskier assets.
The ESRB said this is expected to lead to “a
reduction of technical provisions in downturns” but could also “under specific circumstances incentivise insurers to take on
more risks in upturns”.
Consequently, the ESRB recommended
further study to examine “the possibility to
increase or decrease capital charges for certain types of assets, counterparties or insurance liabilities to address macroprudential
externalities”.
“Unlike the countercyclical buffer that
the Basel Committee designed for banks,
Solvency II does not have a symmetrical
measure – there is no tool to increase solvency requirements in the good times. But
the view among many bank regulators was
that reducing capital requirements in bad
times would not necessarily restore market
confidence, and could even have the opposite effect. The idea of raising capital requirements during a boom is viewed more
22
favourably,” says Paul Sharma, co-head of
financial industry advisory at consultancy
Alvarez & Marsal and a former deputy head
of the UK Prudential Regulation Authority.
Gez Llanaj, director of risk and capital at
accounting firm Mazars in the UK, says there
are quantitative elements to procyclicality as
insurers seek assets to match their book of
life insurance business. He thinks the search
for yield in a low interest rate environment
could lead to clustering in specific products,
and agrees with the ESRB’s suggestion for
closer liquidity monitoring of insurers.
“Regulators would benefit from Solvency
II data related to portfolio allocations that
could provide insights into the order in
which insurers might plan to sell assets for
Paul Sharma
“Solvency II does
not have a tool to
increase solvency
requirements in
the good times”
asset/liability management over a three-year
time horizon, to know if there are any maturity mismatches or concentration risks
that could lead to firesale scenarios,” says
Mr Llanaj.
However, he is doubtful about the idea
of varying countercyclical risk factors to
change insurance capital requirements. Mr
Llanaj feels this runs counter to the spirit of
Solvency II, which was to establish a harmonised regulatory regime that enabled insurers to plan ahead.
“If risk factors will be changed by regulators over the cycle, all projections become
uncertain and it is very difficult to know how
to execute the business plan if the asset and
liability parameters will move, and will not
move together. It is still possible to run a
business like that, but it would be somewhat
dysfunctional at a strategic level,” says Mr
Llanaj.
Another major theme of the ESRB
report was the notion of a double hit affecting life insurance companies in particular:
ultra-low interest rates and falling asset markets. The opening weeks of 2016 have lent
credence to this scenario, as financial market
volatility has gone hand-in-hand with further
extraordinary monetary policy measures in
the eurozone and Japan.
“In Japan this scenario has caused seven
defaults in four years. Insurance guarantee
schemes and recovery and resolution arrangements, currently in place at national
level, are unlikely to be fit to handle such a
scenario. Given the nature of the liabilities,
there could be strong impact on consumers’
confidence in the financial sector and pressure to bail out a large life insurer rather than
let it enter insolvency,” the ESRB warned.
Regulators believe the risks are compounded by the fact that an estimated 50%
of EU life insurance policies can be surrendered without penalty. Certain Belgian life
insurers apparently face structural net cash
outflows already. While the ESRB noted
the lack of consensus among its members
on its countercyclical buffer proposal, Mr
Sharma says the double-hit fears can be
addressed by the European Insurance and
Occupational Pensions Authority (EIOPA)
without fresh legislation.
“The next time EIOPA conducts an insurance industry stress test [in May 2016],
the scenario for the stress test will be provided by the ESRB, so this report has given
us a clear insight into what that scenario is
likely to be,” he says.
The low interest rate environment also
prompted the ESRB to question aspects of
microprudential regulation. Under Solvency
II, long-term life insurance liabilities are discounted based on an assumed ultimate forward interest rate of 4.2%. But the ESRB
noted that this is “well above” current market expectations.
“The question is whether the interest
rate will return to a new, lower normal.
Even if the new normal stops just a few basis
points below 4.2%, that would be a huge difference for the solvency ratios of life insurers,” says Mr Sharma. GRR
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February 2016
Global Risk Regulator
Insurers ask for continuity on
resolution planning
Responses to the Financial Stability Board concept show the industry wants rules that are consistent with
diverse existing practices in each jurisdiction. By Philip Alexander
Insurers continue to press the Financial
Stability Board (FSB) to respect established
protocol for tackling troubled insurance
companies, while casting doubt on their systemic importance. In response to the FSB’s
November 2015 consultation on effective
resolution plans and strategies for systemically important insurers, the industry urged
the narrowest possible definition of “critical
functions” that must be protected at all cost.
The new FSB guidelines would be applied to nine identified global systemically
important insurers (G-SIIs). In a joint response, Andres Portilla of the Institute
of International Finance and Anna Maria
d’Hustler of the insurance think-tank the
Geneva Association called for resolution
strategies that genuinely reflect existing insurer business models.
“We continue to believe very few, if
any, critical functions might be relevant in
insurance. While we appreciate the enhancements included in the consultation to
better account for the insurance business
model, the analysis required to identify the
critical economic functions is still quite extensive,” the response said.
Martina Baumgaertel, head of group
regulatory affairs at Germany’s Allianz, one
of the nine G-SIIs, emphasised that the designation of a critical function “may have far
reaching consequences for the business/legal structure of an insurer” in terms of its
operational continuity. She tells GRR that
Allianz does not believe, based on current
definitions, that it operates anything that
would classify as a critical function.
“We therefore kindly ask to further
clarify the very purpose of the critical functions concept. If it is primarily about consumer protection, the policy choices made
under prudential regulation should generally be respected,” for instance the 99.5%
confidence level embodied in Solvency II,
Ms Baumgaertel said in her letter. “There is
no zero-failure regime at an acceptable cost
to policyholders,” she added.
Above all, there is a broad consensus that
the run-off or sale of insurance portfolios as
February 2016
part of a court-approved process is generally the best approach to resolution. This is
in stark contrast to the kind of emergency
measures needed to avoid the disruptive
failure of a bank. The Global Federation of
Insurance Associations (GFIA) underlined
the fact that insurers usually fail over time,
providing the opportunity for a managed
resolution process that regulators should
handle in a proportionate way.
“Liquidation and winding-up should only
be used in exceptional cases of insurance
failure and as a last resort, as they destroy
value in a portfolio designed for buy to
hold,” warned the GFIA.
The FSB will also need to finalise a regime that respects a crucial transatlantic divide in attitudes to policyholder protection.
This concept is generally enshrined in law
in the US, and state policyholder protection
schemes financed by all the licensed insurers in the state are designed to provide additional security for policyholders.
Steven Bennett, associated general counsel at the American Insurance Association,
objected to the FSB’s proposal that resolution strategies should aim to maintain financial stability “to the fullest extent possible”.
He warned that this could be interpreted as
implying limitations on the priority of policyholder protection.
“In our view, policyholder protection
is a paramount goal and is itself critical to
maintaining financial stability. Indeed the
reason insurers are heavily regulated in the
US is to enhance policyholder protection.
The consultative document should not be
subject to an interpretation suggesting policyholder protection is a goal that may be
sacrificed,” said Mr Bennett.
This stance has the backing of the
National Association of Insurance
Commissioners (NAIC), which represents
US insurance regulators at the state
level. The NAIC requested the FSB to
include more recognition of policyholder
protection schemes as guardians of
financial stability by maintaining consumer
confidence in insurers, and as key
globalriskregulator.com
participants in any resolution process.
By contrast, the major concern among
European insurers was the proposal for
some form of loss-absorbing capital that
would allow the bail-in of bondholders. In
the EU, most regulators retain the flexibility
to reduce policyholder payouts as part of an
insurance restructuring deal.
“We believe that, as a last resort, restructuring policyholder liabilities can be
a powerful tool in recovering a distressed
insurance undertaking – this is something
that the German supervisor has authorised for over 100 years. However, other
bail-in instruments are not appropriate due
to the specific structure of insurers’ balance sheets – 90% of liabilities are policyholder reserves, third party debt is at a very
low level and the rest is equity,” says Ms
Baumgaertel.
The FSB has delayed a decision on
whether to designate reinsurers as G-SIIs
since November 2014. The European industry body Insurance Europe used the FSB
consultation on resolution to play down the
systemic significance of reinsurers.
“Notwithstanding the very important
role they play in supporting the activity of
primary insurers by pooling tail risk globally, the interconnections between reinsurers and the rest of the financial system are
unlikely to prove problematic from a systemic perspective. In fact, only around 5%
of global primary insurance premiums are
ceded to reinsurers,” Insurance Europe said
in its response.
However, this is not a consensus view.
The UK Institute and Faculty of Actuaries
noted the risk of contagion between institutions in the event of a reinsurance failure.
“There are issues around the impact on
some third-party policyholders either directly or through effects on the solvency of
their insurer from the failure of reinsurance
policies. This follows given the ranking of reinsurance policies in an insolvency in some
jurisdictions, if reinsurance is to be protected in some way,” said Steven Graham, technical policy manager at the Institute. GRR
23
Global Risk Regulator
Diary: conferences, meetings and deadlines
February 2016
Feb 12 Deadline for responses to Basel
Committee on Banking Supervision consultation on cross-holdings of total lossabsorbing capacity securities.
Feb 12 Deadline for responses to EBA
consultation on supervisory treatment
of credit valuation adjustment risk
Feb 16 Deadline for responses to
European Securities and Markets
Authority consultation on validation of
credit ratings agencies methodologies
www.esma.europa.eu
Feb 19 Comments due for Federal
Reserve (Fed) consultation on implementing the US Basel III Countercyclical
Capital Buffer (CCyB) which will be
phased in from 2016.
www.federalreserve.gov
Feb 22 Deadline for comments on
CFTC proposed rule on systems safeguards testing requirements for derivative clearing organisations
Feb 22 Comments due on SEC’s proposed amendments to the form and
manner in which security-based swap
data repositories (SDRs) will be required
to make security-based swap data available to the SEC that will be published on
the SEC’s website
www.sec.gov
Feb 23 Deadline for responses
to Committee on Payments and
Market Infrastructures/International
Organisation of Securities Commissions
(Iosco) consultation on cyber resilience
for financial market infrastructures
www.iosco.org
Feb 25 Association for Financial
24
Markets in Europe fixed income and FX
market liquidity conference, London
Feb 25-26 Institute of International
Finance conference on G20 Chinese
presidency agenda, Shanghai
Feb 26 Deadline for responses to US
Securities and Exchange Commission
(SEC) proposal on regulation of NMS
stock alternative trading systems
www.sec.gov
Feb 26-28 US National Conference of
Insurance Legislators spring meeting,
Little Rock
Feb 29 Comments due on Financial
Accounting Standards Board (FASB)
proposed Accounting Standards
Update,‘Fair Value Measurement:
Disclosure Framework – Changes to the
Disclosure Requirements for Fair Value
Measurement
www.fasb.org
Mar 15 Finadium annual conference
focusing on collateral management technology and blockchain for securities processing. India House Club, One Hanover
Square, New York City
www.finadium.com
Mar 16 Deadline for comments on
CFTC proposed rule on automated
trading
Mar 17 Deadline for responses to Basel
Committee consultation on identification and measurement of step-in risk
Mar 17 ISDA workshop on the SIMM,
New York
Mar 17 ISDA conference on upcoming
EU financial legislation and its effect
on commodity market participants,
London
Mar 28 Deadline for responses to SEC
proposal on use of derivatives by registered investment companies
March 2016
april 2016
Mar 2 International Swaps and
Derivatives Association (ISDA) working group on margin requirements
workshop on the standard initial margin
model (SIMM), London
www.isda.org
Mar 7 UK senior managers’ regime for
banks and insurers comes into force.
Mar 11 Deadline for responses to Basel
Committee second consultation on a
revised standardised approach for credit
risk
Mar 13 Deadline for responses to EBA
consultation on assessment methodology on the use of internal models for
market risk
apr 1 CFTC final margin requirements
for uncleared swaps by swap dealers
and major swap participants not supervised by prudential regulators becomes
effective
www.cftc.gov
apr 3-6 US National Association of
Insurance Commissioners spring national
meeting, New Orleans
www.naic.org
april 5 US bank 2016 comprehensive
capital analysis and review (CCAR) stress
test results due for submission to Fed
www.federalreserve.gov
april 12 ISDA annual general meeting,
Tokyo
globalriskregulator.com
February 2016