Bank of England’s Sam Woods on regulatory arbitrage and off-balance sheet leverage

Selected passages from “Looking Both Ways” speech given by Sam Woods, Deputy Governor, Prudential Regulation and CEO, Prudential Regulation Authority 

“I am especially mindful that financial institutions will always be able to innovate faster than we are able to modify the prudential rulebook. In order to remain fit for purpose, the prudential regulatory framework must be responsive to changes in the behaviour and structure of the financial system and identify any gaps, faults or incoherence that can lead to perverse behaviour. This is why we need well-informed rule-makers and alert supervisors, who together can smell when something is off and decide what to do about it.

“We have noticed that some institutions are now moving on-balance-sheet financing to off-balance-sheet formats using special purpose vehicles, derivatives, agency structures or collateral swaps. Some of these structures might meet the detailed requirements for calculating a specific financial ratio whilst others may have a harmless motivation. But we have noticed that some carry material credit risk which escapes the detailed aspects of the capital framework. When setting up these transactions, firms should be prepared for questions from supervisors about the substance, as well as form, of their proposals.”

On LCR-related workarounds: 

“We are aware of banks seeking out funding that matures just beyond the time horizon used to calculate regulatory liquidity requirements. These include the Liquidity Coverage Requirement’s (LCR) 30-day window.

“If a firm subject to the LCR accepts a deposit that can be withdrawn by giving less than 30 days’ notice, it has to hold a certain amount of high-quality liquid assets as insurance against the deposit being withdrawn during stress. As yields on high-quality liquid assets are relatively low, this can drag down profitability. But a bank can evade this by obtaining a deposit that matures after 30 days, since these deposits generate no requirement for counterbalancing high-quality liquid assets.

“I recently saw a term-sheet for an evergreen 35-day call account. In previous times, the market-standard notice period was one calendar month. Why the shift from one-month to 35 days? The traditional one-calendar-month call account is only sometimes LCR-friendly – during a 31-day month – whereas the new 35-day product always is.”

Read the full speech

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