Changes to Basel III rules on the calculation of Exposure at Default (EAD) should result in considerable reduction of RWA penalties for bank-affiliated agent lenders. We speak with Chelvi Paramanathan, global head of Pricing and Analytics for Agency Securities Finance and Collateral Services at J.P. Morgan, about expected impacts of the revisions in effect from January.
Paramanathan can see the impacts of Basel IV revisions from both an agent lending and principal sides. She’s had previous experience in prime brokerage and fintech building models for balance sheet, collateral and risk weighted asset (RWA) optimization. She now manages the financial resource usage for J.P. Morgan’s agency lending business.
The Basel III endgame, also known as Basel IV, introduces sweeping changes in the standardized comprehensive approach for securities financing transactions (SFTs) and brings in considerable reduction of Standard RWA and capital footprint for agent lenders.
The exposure at default (EAD) formula provides a more risk sensitive approach to instrument haircuts by allowing correlation and diversification netting. This will mean increased netting between loan and collateral legs rather than independently assessing the haircut requirements as before the rule changes, Paramanathan explained.
The netted result of the loan/collateral legs will be 40% of the instrument haircut, while the remaining 60% is calculated from gross exposure, which is where the diversification benefit applies. The haircut reduction naturally will happen through this change.
Diversification benefits
Because J.P. Morgan maintains a diversified collateral set and clients, Paramanathan expects the bank will “make the maximum” benefit, and on the flip side, those firms that have more concentrated names in the collateral pool will not gain as much.
The netting and diversification benefits are further boosted by a reduced risk weight for investment grade corporates and small- and medium-sized enterprises (SMEs). In securities lending, broker-dealers tend to be a dominant force for borrowing, and this group’s current risk weight of 100% is going down to 65%.
“If you have a significant balance with broker dealers, you know your risk weight on the exposure at default is dropping by 35%, it has a significant drop in your capital allocation as well,” said Paramanathan.
One negative outcome in Basel IV for agent lenders are minimum haircut floor requirements for SFTs will disqualify repos with low haircut but the impact is not so significant compared to the benefit on the correlation and diversification benefit, she added.
“Given that [J.P. Morgan’s agent lending business] have already taken a very punitive standardized comprehensive approach and we are managing our RWA footprint at optimal level with that punitive approach, this reform is bringing in a more sweeping benefit with this correlation and diversification benefit and the reduction in the risk weight for investment grade counterparties,” said Paramanathan.
In Finadium’s recent agent lender survey, we considered the extent to which bank-affiliated agent lenders could save on indemnification costs, and we’ve heard there could be as much as a 70% improvement. Paramanathan declined to put a specific figure on such an estimate because the impact depends on the location, type of bank and proprietary models used, but agreed that agent banks using the standardized comprehensive approach for RWA assessment will see “meaningful reduction.”
Looking outside the US, she noted that banks using an internal rating-based approach may not see the benefit and furthermore get penalized, particularly on the principal side that faces lenders as counterparties that are considered investment grade entities but don’t have an external rating. This is due to the shift to a higher risk weight to meet the minimum floor requirement from 75% to 100%, depending on the regulatory requirement of the region.