n the aftermath of the 2008 financial crisis, lawmakers and regulators promulgated sweeping regulations that sought to reduce systemic risk and promote market stability. A centerpiece of that effort is Basel III, the international framework that seeks to increase capital buffers and reduce leverage at the largest banks. While PIMCO believes the efforts to improve the resilience and stability of the financial system are important, we worry that certain aspects of the Basel rules in their current form could have unintended – and in many cases undesirable – consequences for investors, specifically those who use derivatives. Moreover, we worry that some of the rules, if misapplied, could lead to more systemic risk – an outcome that would be anathema to regulators.
Increasing capital and reducing leverage are at the heart of the recent rules issued by bank regulators in the U.S. and globally. The rules, which include the supplemental leverage ratio (SLR) and the net stable funding ratio (NSFR), require that banks hold more capital to support their various trading activities in the event that there is a market disruption. These activities include the trading of derivatives, which banks do both as clearing brokers in cleared derivatives trades (in which they act as conduits between end users and central clearinghouses) and as primary counterparties in uncleared derivatives trades (in which banks trade with end users directly, using their own balance sheets).
Under these capital rules, banks would be required to hold significant – and many would say excessive – capital to support derivatives trading activities, even when banks are merely functioning as conduits (i.e., not taking positions of their own). For instance, the rules as they are currently constructed would prevent banks, when acting as clearing brokers, from receiving “credit” in their leverage ratios for segregated initial margin posted by their clients, thereby requiring them to hold more capital for these transactions even though segregated initial margin expressly mitigates risk.
This requirement seems to be due to the concern that a clearing bank may have the ability to reinvest a client’s initial margin in such a way as to leverage itself, but in fact, margin is legally separated and cannot be re-hypothecated in the U.S. (source: U.S. Code of Federal Regulations (CFR), Title 17). The rules would also require that banks fund both initial and variation margin at long-term funding rates, which would increase costs significantly, according to a January 2015 study on the NSFR by Oliver Wyman.
Why does this matter? Should these capital requirements remain in place for derivatives activities, banks likely will find it too costly to perform vital functions around derivatives trading as is, which either will lead them to pass on the increased costs to end users (e.g., investors, including PIMCO clients) or cause the banks to exit the clearing business altogether. Already, we have seen both, and neither is desirable. Increased costs passed on to end users in cleared transactions may lead them to prefer uncleared, over-the-counter derivatives, which would be inconsistent with the G-20’s goals of moving derivatives to cleared space and reducing counterparty exposure. Having fewer clearing brokers would also be unwelcome, as it would consolidate more risk among fewer members and make “portability” – the ability to transfer trades from one bank to another and an important element of clearing – significantly more difficult, thereby potentially increasing systemic risk.
The good news is that there is growing recognition of this issue and increasing calls from lawmakers and regulators alike to change the Basel III rules to make the treatment of derivatives more reflective of the actual risks. In fact, Commodities Futures and Trading Commission Chairman Timothy Massad, in a House Agriculture Committee hearing on 12 February 2015, stated regarding the new capital requirements: “I’m very concerned that this could have a significant negative effect on clearing.” Similarly, in a letter to the Federal Reserve, Representative Mike Conaway (R-TX), chairman of the House Agriculture Committee, and Representative Collin Peterson (D-MN), the committee’s ranking member, warned that “many prudentially regulated entities may find this unwarranted treatment grounds for discontinuing their customer-facing clearing business … the resulting consolidation would undermine key market reform principles of encouraging derivatives clearing and mitigating systemic risk.”
We would reiterate these points and encourage the Basel Committee on Banking Supervision and the Federal Reserve to revisit the rules as they relate to capital requirements for derivatives trading, specifically by reassessing the treatment of client margin in leverage ratios and the requirements for funding. Should these rules not change, in our view the cost of transacting in the markets will continue to increase and risks will become more concentrated in the hands of fewer market participants, creating a more interlinked and fragile market system that is more vulnerable to dislocations.