This edition of News Roundup covers some important issues in securities finance and regulation, including how banks model risk assets, posting illiquid collateral for bilateral trades, the ECB’s money market survey and CCP transparency.
The Standardized Approach. In an important move, the Basel Committee on Banking Supervision is recommending more attention to the standardized approach for calculating the risk weights of assets, and less focus on the internal models that banks have been allowed to rely on. These internal models create discrepancies between banks and make stress tests less useful for regulators. They also make it well neigh impossible to understand identical risks between banks – there are no apples to apples comparisons here. The Basel Committee wants banks to start measuring the standardized approach and making the resulting capital charges public. More information can be found in the Oct 31 publication, “Fundamental review of the trading book – second consultative document.” Banks pushed back even before the publication was released. According to Risk.net, a UBS senior risk controller said that the standardized approach would create more systematic risk in the markets. Not sure we understand how the internal market models approach reduces systematic risk, but there you have it.
Posting low quality collateral for non-cleared swaps trades. In a move that echoes the Federal Reserve’s conversations about fire-sale risk, Risk.net reports that banks are posting low quality, illiquid collateral on bilateral swaps trades in order to reduce capital charges (“Bank initial margin posting raises liquidation concerns“). For banks this is a smart and logical move; they will now be taking all steps to reduce capital charges. Regulators however are worried that banks posting illiquid assets would lead to massive liquidation problems in case of a dealer default. The solution would be to post high quality assets as collateral, but there is only so much of that to go around. While we agree that well collateralized trading is the best way to go, we also suggest that regulators have created a new requirement for trading without providing solutions.
The ECB on money market funds. In a report that we’ve come to regard as an important benchmark of market activity, the European Central Bank released its 2013 Euro Money Market Survey. Some of the highlights include a move from unsecured to secured lending and an increased use of CCPs:
“In the unsecured market, cash borrowing of the banks on the panel decreased by 44%, to €1.75 trillion, while their lending declined by 17%, to €1.46 trillion.”
“The secured market remained the largest segment. Total turnover in secured lending and borrowing rose by 17%, to €30 trillion, mainly on account of a 27% increase in activity relating to overnight maturities, while turnover for maturities of between “tomorrow/next” and one week increased by 16%.”
“71% of all bilateral repo transactions were cleared by central counterparties, compared with a revised figure of 56% in 2012.”
The survey covers almost 200 large European banks across the EU.
“Who watches the Watchmen? Um, the CCPs?” Edwin Schooling Latter of the Bank of England’s payments and infrastructure group has spoken again about the need for CCPs to operate transparent models. Speaking at the Asia Risk conference in Hong Kong (and covered by Risk Magazine here), he said “How does a CCP model a future? It looks at the past, but what look-back period does it use? If it uses the buoyant past two months when markets are doing well, then that’s different to a 10-year time frame or a stress period. Also, for what period will it hold a defaulter’s position before it is liquidated or replaced? Ten days, five days or one day? These decisions will have a big impact on the amount of margin required.” Buyer beware”: CCP users should know what a CCPs risk model is and be careful that it is credible.
This isn’t the first time that Mr. Latter has spoken publicly on CCPs, transparency and bankruptcy. On a centralbanking.com online panel, he noted that said “the world of bailout scenarios ‘has ended’. If a CCP defaults, he said, any losses not borne by the defaulter’s margin – that cannot be absorbed by mutualised resources it has collected – will fall on its creditors.” These are strong words, but even as CCPs work to raise liquidity pools to withstand a default, we continue to think that moral hazard exists in the form of implicit government guarantees. Could governments really withstand the political fallout from so much disruption to financial systems and hence the real economy? We are inclined to say no.