Did the BIS give the securities financing business a (slightly delayed) Christmas gift?

The BIS published their long awaited update to capital rules and the securities financing world is cheering. “Basel III leverage ratio framework and disclosure requirements” (January, 2014) permits netting of financing trades, subject to certain constraints, when calculating how much capital a bank needs to hold. But in the process, the BIS may have reinforced the non-level playing field between those institutions using GAAP reporting and those utilizing IAS.

The use of a simple non-risk based capital calculation sent shivers down the collective spines of the securities financing world. By incorporating a very straightforward calculation that could not be gamed, the fear was that repo, for example, would now be bound by capital considerations. Repo is typically a very capital friendly business. In-between netting and assets that don’t absorb much RWA in the first place, little balance sheet and hence capital was required to support the enterprise. However the use of a “capital divided by exposure” calculation ropes in a business that is balance sheet intensive without any consideration of how risky it is. Securities financing was the poster child for businesses that would now be primarily constrained by what was designed as a “backstop measure”. Adding insult to injury, the BIS’ 3% leverage ratio is subject to national regulators add-ons (a/k/a Supplemental Leverage Ratios) for systemically important banks. In the U.S., impacted bank holding companies would have to clock in at 5% and insured depository subsidiaries at 6%.

The netting language in the BIS paper looks like what many banks are using already to net repo trades. The verbiage looks like this:

 “…(a) Transactions have the same explicit final settlement date;

(b) The right to set off the amount owed to the counterparty with the amount owed by the counterparty is legally enforceable both currently in the normal course of business and in the event of: (i) default; (ii) insolvency; and (iii) bankruptcy; and

(c) The counterparties intend to settle net, settle simultaneously, or the transactions are subject to a settlement mechanism that results in the functional equivalent of net settlement, that is, the cash flows of the transactions are equivalent, in effect, to a single net amount on the settlement date. To achieve such equivalence, both transactions are settled through the same settlement system and the settlement arrangements are supported by cash and/or intraday credit facilities intended to ensure that settlement of both transactions will occur by the end of the business day and the linkages to collateral flows do not result in the unwinding of net cash settlement…”

The use of netting, however, is also controlled by which accounting regime an institution uses at the parent level. GAAP is considered more netting friendly than IAS. This can create a uneven playing field, primarily between US banks on GAAP and European banks on IAS. While US based foreign bank subsidiaries utilize GAAP for local reporting to regulators, ultimately their balance sheet is calculated using IAS rules – and limits and controls should be set on the parent reporting level and flow back down. Stricter IAS netting (vs. GAAP) means absorbing more capital for a given balance sheet.

To achieve netting efficiencies, there have to be offsetting trades to net. Banks go through the fire drill of entering into offsetting trades with counterparties each statement date just for the purpose of netting down balance sheet. Open trades, which are not considered offsetting, are switched to specific maturity dates. But not every client has the capacity to do the offsetting trades. For those clients, financing costs are higher since the capital absorbed is higher. The 3% BIS capital rules, as well as the SLR, will hurt those trades since they will become even more capital intensive.

Critics will say that allowing netting in securities financing simply perpetuates the ability to leverage all you want with little transparency. After all, repo leverage gone bad has taken down more than a handful of firms. The banks have won this round with the BIS, but remember there are lots of other battles with the regulators brewing over securities financing and the year is still very young.