The International Securities Lending Association (ISLA) submitted a response to the Bank of England’s consultation paper on the Implementation of the Basel 3.1 standards in the UK. ISLA’s response raises concerns around the capital treatment of unrated entities.
Basel III standards are the final part of the post-2008 crisis reforms and they address the amount of capital that banks need to hold versus the risks they take. Many of these standards have already been implemented in the UK through EU legislation. The latest phases focus on increasing the quantity and quality of capital maintained by firms, and also introduce new requirements for leverage and liquidity.
An analysis performed by S&P Global and Credit Benchmark in 2022 found that on average the credit quality of funds that lend securities in Europe were mostly found to be of the highest credit quality. This analysis also showed that after liaising with large IRB banks, a typical risk weight for high quality mutual and pension funds is approximately 12.5%.
Considering that the majority of funds do not have an external rating, but are mostly considered investment grade, the risk weights for these types of counterpart would increase on average from 12.5% to 65%. It is important to note that ratings are typically used by issuers of securities to raise capital. Conversely, unrated funds, such as mutual and pension funds, do not have a need for an external rating, as they generally do not require access to capital and thus the costs and compliance burden of obtaining an external credit rating is unwarranted.
As a result, ISLA is concerned that many banks may reconsider their SFT business, or subsequently pass on the increased costs to their counterparties, who in turn, would likely find such activity uneconomic, unless there were exceptional circumstances. Therefore, SFT activity, and counterparties’ access thereto, would be severely restricted. This would, in turn have serious implications for financial trading activities, market making, hedging and other financial risk-management activities that securities lending facilitates.
The consultation paper concentrates on the measurement of risk weighted assets, revising the calculation by improving both the measurement of risk in internal models (IMs), standardised approaches (SAs), and the comparability of risk measurement across firms.
Also, the International Swaps and Derivatives Association (ISDA) and the Association for Financial Markets in Europe (AFME) submitted a joint response.
The consultation response includes proposals for targeted revisions to the output floor, credit risk, credit risk mitigation, credit valuation adjustment risk, standardized approach for counterparty credit risk, market risk and operational risk frameworks to improve the risk sensitivity of the requirements, reduce unnecessary burdens on firms and ensure that corporates and other end users are still able to access key financing, liquidity, and hedging services at a reasonable cost.
Specific to securities financing transactions (SFTs), the response considers treatment of trading book instruments used as collateral for SFTs, in-scope transactions, and several definitional items.
One area where the revised Basel 3.1 framework results in a significant increase in capital requirements relates to SFTs. Under the revised framework, there is no significant change to how the Internal Model Method exposures and the Internal Rating Based risk weights are calculated.
However, the standardized approach for credit risk, or SA-CR, adds a significant level of conservatism through the application of the output floor by not recognizing the very short-term nature of SFTs. The unintended impact of the RWA output floor could lead to an increase in RWAs, thereby potentially rendering the SFT business uneconomical for the banks that are active in the wholesale market, of which SFTs form a very important component. Such an outcome could threaten liquidity benefits for all stakeholders, from issuers (higher cost) to end investors (lesser liquidity).
ISDA and AFME recommended an amendment to the SA-CR treatment of derivatives and SFTs by introducing a short-term maturity adjustment.