Basel Committee consultation on the Leverage Ratio specifies treatment of collateral and securities finance transactions

We note the following sections of the Basel Committee on Banking Supervisions new consultative document, “Revised Basel III leverage ratio framework and disclosure requirements.”

25. Bilateral netting: when an eligible bilateral netting contract is in place as specified in paragraphs 8 and 9 of Annex 1, replacement cost (RC) for the set of derivative exposures covered by the contract will be the net replacement cost and the add-on will be ANet as calculated in paragraph 10 of Annex 1.

26. Treatment of related collateral: collateral received in connection with derivative contracts has two countervailing effects on leverage:
• it reduces counterparty exposure; but
• it can also increase the economic resources at the disposal of the bank, as the bank can use the collateral to leverage itself (eg cash collateral can be on-lent, non-cash collateral can be on-lent or sold).

27. Collateral received in connection with derivative contracts does not reduce the economic leverage inherent in a bank’s derivatives position. In particular, the exposure arising from the contract underlying is not reduced. As such, collateral received (cash or non-cash) may not be netted against derivatives exposures whether or not netting is permitted under the bank’s operative accounting or risk- based framework. When calculating the exposure amount by applying paragraphs 23 to 25 above, a bank must not reduce the exposure amount by any collateral received from the counterparty. Furthermore, the replacement cost (RC) must be grossed up by any collateral amount used to reduce its value, including when collateral received by a bank has reduced the derivatives assets reported on- balance sheet under its operative accounting framework.

28. Similarly, with regards to collateral provided, all banks must gross up their Exposure Measure by the amount of any derivatives collateral provided where the provision of that collateral reduced their on-balance sheet assets under their operative accounting framework.

34. Securities financing transactions (SFTs)19 are included in the Exposure Measure according to the following treatment. The treatment recognises that secured lending and borrowing in the form of SFTs is an important source of leverage and ensures consistent international implementation by recognising the main differences across accounting frameworks.

35. General treatment (bank acting as principal): the sum of the amounts in (i) and
(ii) below are to be included in Total Exposures:

(i) Gross SFT assets recognised for accounting purposes (ie with no recognition of accounting netting).20
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).21
(ii) A measure of counterparty credit risk calculated as current exposure without an add-on for potential future exposure (PFE).
• Where no qualifying master netting agreement (MNA) is in place, the current exposure for transactions with a counterparty must be calculated on a transaction by transaction basis: that is, each transaction is treated as its own netting set, as shown in the following formula:
E* = max {0, [(E) – (C)]}
• Where a qualifying MNA22 is in place, the current exposure (E*) is the greater of zero and the total fair value of securities and cash lent to a counterparty for all transactions included in the qualifying MNA (∑(E)) less the total fair value of cash and securities received from the counterparty for those transactions (∑(C)). This is illustrated in the following formula:
E* = max {0, [∑(E) – ∑(C)]}

36. Sale accounting transactions: leverage may remain with the lender of the security in an SFT whether or not sale accounting is achieved under the operative accounting framework. As such, where sale accounting is achieved for an SFT under the bank’s operative accounting framework, the bank must first reverse all sales-related accounting entries, and then calculate its exposure as if the SFT had been treated as a financing transaction under the accounting framework (ie in this last step, the bank must include the sum of amounts in (i) and (ii) above for such an SFT) for the purposes of determining its Exposure Measure.

37. Bank acting as agent: a bank acting as agent in an SFT generally provides an indemnity or guarantee to only one of the two parties involved, and only for the difference between the value of the security or cash its customer has lent and the value of collateral the borrower has provided. In this situation, the bank is exposed to the counterparty of its customer for the difference in values rather than fully exposed to the underlying security or cash of the transaction (as is the case where the bank is one of the principals in the transaction). Where the bank does not own/control the underlying cash or security resource, that resource cannot be leveraged by the bank. The following exceptional treatment therefore applies for a bank acting as agent in an SFT and providing an indemnity or guarantee.

38. Where a bank acting as an agent in an SFT provides a guarantee to a customer or counterparty for any difference between the value of the security or cash the customer has lent and the value of collateral the borrower has provided, then the bank will be required to calculate its Exposure Measure by applying only section (ii) of paragraph

39. A bank acting as agent in an SFT and providing a guarantee to a customer or counterparty will be considered eligible for this exceptional treatment only when the bank’s exposure to the transaction is limited to the guaranteed difference between the value of the security or cash its customer has lent and the value of the collateral the borrower has provided. In situations where the bank is further economically exposed (ie beyond the guarantee for the difference) to the underlying security or cash in the transaction23 a further exposure equal to the full amount of the security or cash must be included in the Exposure Measure.

Annex 1:

12. Qualifying master netting agreement: the effects of bilateral netting agreements covering repo- style transactions will be recognised on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:

(a) provide the non-defaulting party with the right to terminate and close out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;
(b) provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other;
(c) allow for the prompt liquidation or setoff of collateral upon the event of default; and
(d) be, together with the rights arising from provisions required in (a) and (c) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default regardless of the counterparty’s insolvency or bankruptcy.

13. Netting across positions in the banking book and trading book will only be recognised when the netted transactions fulfil the following conditions:

(a) All transactions are marked to market daily, and
(b) The collateral instruments used in the transactions are recognised as eligible financial collateral in the banking book.

The full document is available here. Comments are due by September 20, 2013.

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