We’ve seen a number of interesting reports from regulators over the last week that we are just now getting to. Here’s a summary of what we found important.
1) The Bank of England’s Financial Stability Report from June 2013 had mostly what you would expect, but check out the box that starts on page 10 with a discussion of factors that could exaggerate risk taking in financial markets. “Symptoms of exaggerated risk taking among investors might include elevated appetite for duration, credit and liquidity risk. Increasing balance sheet leverage is also a potential feature, as are the popularity of relatively complex instruments with greater sensitivity to underlying economic outcomes — so-called ‘embedded leverage’.”
Our research, including our just released report on hedge funds on leverage, repo and prime custody, suggests this is a major flash point in the making.
2) The Basel Committee on Banking Supervision released “Capital treatment of bank exposures to central counterparties,” a consultation paper. According to the BCBS, “The objective of the suggested changes is to establish a capital treatment that ensures banks’ exposures to central counterparties are adequately capitalised, while also – in support of the G20 mandate to clear centrally all standardised over the counter derivatives – preserving incentives for central clearing, and promoting robust risk management by banks and CCPs…. The changes respond to evidence that application of the interim rules could lead both to instances of very little capital being held against exposures to some CCPs, and potentially in certain cases, to capital charges higher than for bilateral transactions.”
We’ve been working on this issue ourselves and agree that there are some major guesses here about capital charges for each of a bilateral and CCP transaction; clarifying capital charges is helpful. At the same time, the explicit goal here is supporting CCPs, which we can all agree are not necessarily going to end risk as we know it, but rather are supporting vehicles that should be paired with bilateral transactions as appropriate. The BCBS document is worth a read for any risk manager dealing with CCPs.
3) Another BCBS consultation paper, “The non-internal model method for capitalising counterparty credit risk exposures,” tries to tackle the amazing amount of non-conformity in analyzing counterparty credit risk exposure. Given the prevalence of internal model methods for calculating counterparty risk, not to mention RWA, this paper isn’t a must read unless a firm is directly affected.
4) While not a regulatory release, we strongly recommend a glance at an article in International Financing Review, “Basel bond confounds in India” The article deals with the issuance of new Basel III compliant bonds by 82.3% government owned United Bank of India that have generated confusion by meeting new rules without the rules having yet been fully defined by regulators.
According to the article “…the new bonds include a clause that converts them to equity if the bank’s core equity Tier 1 capital falls below a level yet to be defined by regulators, effectively wiping out investors to keep the bank afloat. Meanwhile, the old bonds would only be scrapped in the case the bank became insolvent.” Mighty confusing indeed.