All roads lead to grossing up of repo exposures, so far

Following talk about a further diminished US repo market in the near future, we did some investigating to find the rules, regs and implications that suggest why this might happen. Sure enough, we conclude that US and international rules are driving towards grossing up of repo exposures on balance sheets, putting pressure on SIFIs, G-SIBs and their similarly regulated cousins to change repo behavior.

At immediate issue is a Notice of Proposed Rulemaking (NPR) issued by the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC, “Regulatory Capital Rules: Regulatory Capital, Enhanced Supplementary Leverage Ratio Standards for Certain Bank Holding Companies and Their Subsidiary Insured Depository Institutions” (published in the Federal Register on August 20, 2013). The main purpose here is reducing Too Big To Fail, and this document sets out proposals for how a Supplementary Leverage Ratio (SLR) would be calculated, what its purpose would be and who would be affected. The SLR would need to be calculated “as of the last day of each month in the reporting quarter.” This is a step faster than the end-of-quarter reporting that banks have done historically. The SLR, with a 5% ratio for big bank holding companies, and 6% for their insured depository institutions, is likely to come into being in some form in 2018.

Meanwhile in late July, JPMorgan issued a research note saying that by not allowing netting of repo, the SLR would choke the repo markets. According to JPM, “As with derivatives, the proposals do not allow netting of collateral, i.e. repos are accounted for on a gross basis in the calculations of the Exposure Measure.” The FT had a good write up of the JPM comments here.

The JPM note goes a little further in its implications than what we read, presuming that both on-balance sheet and off-balance sheet repos would need to be grossed up. But according to the published SLR proposals:

“The supplementary leverage ratio is the ratio of tier 1 capital to total leverage exposure, where total leverage exposure is the sum of (1) on-balance sheet assets less amounts deducted from tier 1 capital, (2) potential future exposure from derivative contracts, (3) ten percent of the bank’s notional amount of unconditionally cancellable commitments, and (4) the notional amount of all other off-balance sheet exposures except securities lending, securities borrowing, reverse repurchase transactions, derivatives, and unconditionally cancellable commitments.

While we agree that on-balance sheet exposures are suggested as needing to be grossed up, that doesn’t seem to hold true for off-balance sheet exposures as well. A big problem is that we don’t know how much current repo business is on or off balance sheet, nor how they can be moved around. But not to mince words – the potential impact for repo is still large – and it looks like how much repo gross up will occur depends on how exposures are characterized.

We note also that the US conception of the SLR is a bit different than the Basel III version:

“The BCBS focused on calibrating the Basel III leverage ratio to be a backstop to the risk-based capital ratios and an overall constraint on leverage. The [US] agencies believe that… further steps could be taken to ensure that the risk-based and leverage capital requirements effectively work together to enhance the safety and soundness of the largest, most systemically important banking organizations.”

Meanwhile, the most recent Basel III consultation document on calculating exposures in the Leverage Ratio, “Revised Basel III leverage ratio framework and disclosure requirements,” tells a similar story (see the text below – its a little wonky to get into here). We understand that CCP transactions where contracts are novated can be netted. That could mark massive change in the US if US dealers start clearing repo on CCPs.

We are already seeing the impact of this leverage ratio exposure treatment in European prime brokers taking loans from beneficial owners with whom they have netting agreements vs. those without. At least that helps with the second part of the Exposure Measure.

Whether through the SLR or a convergence between US GAAP and IFRS, it does look like the repo business at the big eight US banks will decline. As the US regulators note, “the direct effect of the proposed rule [SLR] on competition is more likely to be to reduce the market share of the covered institutions.” We don’t think the slack will be taken up by lower rated banks leading to a smaller or more expensive repo market. At least, that’s as far as the private sector is concerned.

Text from “Revised Basel III leverage ratio framework and disclosure requirements Consultation Document”:

Securities financing transactions (SFTs) are included in the Exposure Measure according to the following treatment:

– Gross SFT assets recognised for accounting purposes (ie with no recognition of accounting netting). Remove the value of securities received in an SFT and recognised as an asset by the transferor if the transferor has the right to hypothecate but has not done so (eg under US GAAP). (Note: this is how IFRS handles exposures already.)

– A measure of counterparty credit risk calculated as current exposure without an add-on for potential future exposure (PFE).


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