LCR, NSFR, HQLA? The technical reasons for why that FT article was off base

Following the publication of the FT’s article on November 30, “Regulators’ boost for securities lending has risky implications,” and our reply, “The FT suggests that collateral transformations amount to regulatory arbitrage,” readers provided some very constructive comments. One thing they asked about was a part of the analysis that we hadn’t fully wrapped up: what happens to LCR calculations in a collateral transformation?

For those of you new to the conversation, the FT’s article was a strongly worded attack on securities lending and collateral transformations, in effect suggesting that banks are using transformations to hide their balance sheet risks or weaknesses. In one of the lighter passages, author Patrick Jenkins says that transformations are window dressing: “That premise is worth keeping in mind when considering the booming business of securities lending, the practice among financial institutions of swapping shares, bonds and cash with one another. What are they trying to hide?”

A core part of Jenkins’ argument is that transformations are regulatory arbitrage for HQLA. He says:
Banks are boosting their liquid assets to comply with the new Basel III requirement known as the liquidity coverage ratio.
and

The exchange of assets can be a boon to capital, with equities that tend to attract higher capital weightings swapped for “risk-free” bonds.

Is this accurate? Readers in the FT’s own comment section said no:

Reader “Bal” said:

Based on 10yrs experience within bank regulatory policy the central arguments / entire article is riddled with issues.

1. Under LCR, borrowed securities would only count if bank has rehypothecation rights and securities are free of legal, reg, contractual, other restrictions to monetise etc;

2. Were the bank to recognise the rehypothecated securities as its own assets under GAAP /HQLA for LCR, it would hold RWA/capital on these risk positions. So actually there is a potential RWA / capital increase coming off these trades.

3. For securities borrowing transactions, the equity leg would not be derecognised from the bank’s balance sheet- so RWA/capital would continue to apply and the bank does not ditch the more risky equity assets from its balance sheet.

Reader “JayDee” said:

Regulatory rules require that capital be held against BOTH the equities held and the risk introduced from the stock loan arrangement. There is no regulatory capital advantage here. This does however help meet LCR requirements and rightly so. The arrangement strengthens a banks ability to survive a liquidity stress. No funny business here.

A colleague at a Central Bank told us that collateral transformation trades require that HQLA assume the value of the lesser quality asset. We investigated further and found that this could be considered the outflow rate of Other Contingent Funding Liabilities under the LCR, which are determined by each national regulator.

Re-reading the exact definition of HQLA is helpful. Here’s the (almost) final word, from “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools,” Basel Committee on Banking Supervision, January 2013, on what can be considered HQLA (emphasis added):

31.    All assets in the stock should be unencumbered. “Unencumbered” means free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset. An asset in the stock should not be pledged (either explicitly or implicitly) to secure, collateralise or credit-enhance any transaction, nor be designated to cover operational costs (such as rents and salaries). Assets received in reverse repo and securities financing transactions that are held at the bank, have not been rehypothecated, and are legally and contractually available for the bank’s use can be considered as part of the stock of HQLA.

Footnote 9: If a bank has deposited, pre-positioned or pledged Level 1, Level 2 and other assets in a collateral pool and no specific securities are assigned as collateral for any transactions, it may assume that assets are encumbered in order of increasing liquidity value in the LCR, ie assets ineligible for the stock of HQLA are assigned first, followed by Level 2B assets, then Level 2A and finally Level 1. This determination must be made in compliance with any requirements, such as concentration or diversification, of the central bank or PSE.

39.    Banks should not include in the stock of HQLA any assets, or liquidity generated from assets, they have received under right of rehypothecation, if the beneficial owner has the contractual right to withdraw those assets during the 30-day stress period.

It appears then that collateral transformations can help HQLA so long as the counterparty had not rehypothecated those assets in the first place. This also requires that transformations meet the definition of unencumbered. At the same time, a government bond for equities transaction under 30 days will have a 50% outflow rate in the denominator of the LCR. Its not a free lunch, plus this does not yet consider RWA metrics as noted by FT commenter “Bal” above.

There are no breaks under the NSFR either. The section in italics below shows that a bank lending equities would need to include those equities in their calculation of Required Stable Funding. The borrowed bonds would not count. According to “Basel III: the net stable funding ratio,” Basel Committee on Banking Supervision, October 2014:

32. For secured funding arrangements, use of balance sheet and accounting treatments should generally result in banks excluding, from their assets, securities which they have borrowed in securities financing transactions (such as reverse repos and collateral swaps) where they do not have beneficial ownership. In contrast, banks should include securities they have lent in securities financing transactions where they retain beneficial ownership. Banks should also not include any securities they have received through collateral swaps if those securities do not appear on their balance sheets.

So is Jenkins right? Yes, to a point. Banks can at times improve their HQLA but not always, and always with a negative hit to the LCR denominator, the NSFR and to RWA. There is no free lunch here. We again conclude that Jenkins’ article was very heavy handed in its attack on securities lending and collateral transformations. What a shame.

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