Why gross up exposures for fully collateralized transactions? The ICMA and ISLA respond to new Leverage Ratio proposals.

Two comment letters last week on the Leverage Ratio from ICMA and ISLA draw important attention to how projected Basel III capital rules impact exposure netting. With netting, banks are generally all right under the new regime. Without it, entire business lines (including repo and securities lending) are exposed to limits and capital treatments that may become prohibitively expensive. Following our recent article on grossing up repo exposures (“All roads lead to grossing up of repo exposures, so far“), we take a look at the main issues highlighted by ICMA and ISLA.

After a few niceties, ICMA’s European Repo Council (ERC) gets to the point: “one way in which such negative consequences are likely to be very quickly triggered is to establish a leverage ratio regime on a basis whereby appropriate counterparty netting would be prohibited for repurchase transactions and other securities financing arrangements.” Grossing up repo and securities lending transactions would be very, very damaging, and as the ERC points out, grossing up repo and securities lending exposures does not increase market leverage. Instead of penalizing banks by reducing netting, the Basel Committee could indeed require a grossing up of all exposures and also raise the Leverage Ratio to accommodate the higher values that will result – or give appropriately collateralized transactions with recognized netting agreements the exemption they deserve. Instead, the Basel Committee seems to want to cram all the exposure into one lower Leverage Ratio. This is bad news.

Other topics raised by the ICMA/ERC are:

– No appropriate counterparty netting
– Calculating counterparty credit risk as the net current exposure
– Fails
– Forward asset purchases

The ICMA letter is here. It’s worth a read.

The ISLA letter follows similar themes: “We note that the revised Basel III leverage ratio framework materially changes the calculation of the exposure measure for SFTs. Whilst we appreciate that the leverage ratio is designed to act as a simple, transparent and alternative measure to risk-based capital requirements we are concerned that measuring SFT exposures on a gross basis without any allowance for appropriate netting of transactions will disincentivise banks from undertaking securities lending and repo business.” This is a nice way of saying that the current Exposure Method is a major disaster with multiple adverse and unintended consequences. ISLA also raises a question that we share about how off-balance sheet securities finance transactions should be treated.

While less meaty, ISLA’s letter provides support to both the ICMA ERC letter as well as a comment letter from the US’s RMA (not available on line at this time). ISLA’s comment letter is here.

We think that ICMA and ISLA are fully correct about the importance of allowing exposure netting for the fully collateralized transactions of securities lending and repo. The focus on grossing up exposures does not change leverage and can meaningfully damage financial markets, including government bond markets. We hope that regulators adjust their plans accordingly.

And, in an example that everyone has their own dog in this fight, the US’s Futures Industry Association wrote a comment letter asking for client clearing to be excluded from the Leverage Ratio. How netting gets measured using CCPs is also up in the air. The FIA’s letter is here.

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