Saturday, April 9, 2011

Two Major Tests for Bank Regulators

As I said in my previous post, the new Basel III liquidity requirements are a massive deal, and one of the most important aspects of financial reform, but have been almost completely ignored by commentators as well as the press. As a result, I think it would be useful for me to highlight the most important aspects of the new liquidity requirements that were left to national regulators — and that therefore are still up in the air. I’m only going to address the Liquidity Coverage Ratio (LCR) here, since the other component of the liquidity requirements, the Net Stable Funding Ratio, isn’t scheduled to be implemented until 2018, if it’s ever implemented at all (and I have serious doubts about whether it’ll ever be implemented in anything like its current form, which is barely even coherent).

Broadly, the Liquidity Coverage Ratio requires internationally active banks to maintain a stock of “high-quality liquid assets” that’s sufficient to cover cash outflows in a 30-day stress scenario. In other words, banks are required to have enough cash or cash-like instruments on hand to survive a really horrible, financial-crisis-level 30 days, in which the funding markets all but shut down. The cash outflows in the stress scenario are calculated by applying “run-off rates” to each source of funding (e.g., unsecured wholesale funding, repos, etc.). Most of the action/controversy here is in the different run-off rates used. (I gave a more detailed explanation of the LCR here and here.)

There are, in my opinion, two major issues that still have to be determined by national regulators: (1) the run-off rate for market valuation changes on derivatives transactions; and (2) the definition of, and run-off rate for, so-called “non-contractual contingent funding obligations.” This post will address the first issue. My next post will deal with the second issue (which I’ve come to the conclusion should absolutely be called “the Citigroup rule”).

Market valuation changes on derivatives transactions

The final Basel III document amazingly contains only three sentences on this issue:

Increased liquidity needs related to market valuation changes on derivative or other transactions: (non-0% requirement to be determined at national supervisory discretion). As market practice requires full collateralisation of mark-to-market exposures on derivative and other transactions, banks face potentially substantial liquidity risk exposures to these valuation changes. Inflows and outflows of transactions executed under the same master netting agreement can be treated on a net basis.
To use a familiar example that most people understand, this is the liquidity risk that brought down AIG’s CDS book. AIG entered into CDS contracts which required it to post collateral when the market value of the underlying CDOs fell. By entering into these CDS contracts, AIG took on massive liquidity risk — that is, AIG was exposed to the risk that the market valuation of the underlying CDOs would fall, requiring it to come up with cash to post as collateral. If AIG had been subject to Basel III’s new liquidity rules, it would’ve been required to hold additional “high-quality liquid assets” in its liquidity pool to cover the potential collateral calls.

So what regulators have to determine here is basically how far market valuations on derivatives can fall during a 30-day financial crisis. If the regulators say that market values on, say, the CDX IG contract (a popular index CDS tracking investment-grade corporate bonds) would fall 20% in the 30-day stress scenario, then that’s a 20% run-off rate for CDX IG protection sellers. Obviously, there will have to be different assumptions on market value changes for different products — e.g., the price of high-yield debt would almost certainly fall much further than the price of investment-grade debt in a crisis, so banks that sold protection on the CDX HY contract would experience much greater cash outflows than banks that sold protection on the CDX IG contract. Interest-rate swaps will presumably need different assumptions too — Libor’s volatility, for instance, played havoc with rate swap valuations after Lehman failed.

(Oddly though, the language of the Basel III document suggests that banks that would benefit from market valuation changes on derivatives wouldn’t get to count those cash inflows unless those derivatives were executed under a master agreement with other derivatives that would suffer from the market valuation changes. They couldn’t be counted under any of the separately-defined “Cash Inflows” categories, so the only way those inflows could be counted is if they’re netting off outflows under a master agreement. Personally, I doubt this is what the Basel Committee intended, so I’m expecting this to change when the regulators get into the rulemaking process.)

The reason this is so important is that when you get to the dealer bank level, large market value changes can cause a lot of money to change hands, and if a dealer isn’t running a very flat (i.e., market-neutral) book, it can suffer significant cash outflows. Just ask Morgan Stanley.

Not only are the levels that regulators set here extremely important to the robustness of the liquidity requirements, but they’ll also provide a unique insight into the kind of crisis that regulators think banks should be able to withstand — and, also, into how seriously the regulators are taking the job of writing regulations to prevent another financial crisis.


Anonymous said...

I'm not so sure about your paragraph beginning "(Oddly enough...". I can't claim to be an insider here, but I have recently done some initial impact analysis of these rules for my job. My understanding was that the new rules are expected to provide protection against systematic failure events as well as idiosyncratic institution-by-institution failures. The 100% run-off rates for non-SME, non-operational wholesale MM and corporate deposits looks harsh as a forecast of what would happen to an insitution in a plausible stress scenario, but looks less unreasonable as a way to create "firewalls" in money-markets.

Suppose you have a problem passing the LCR because of liquidity outflows for collateral calls on derivative contracts with counterparty A. If you need to rely on inflows from roughly-hedging contracts with counterparty B, then effectively your ability to survive the stress event is contingent on counterparty B's ability. If B can't meet your calls, you won't meet your calls and other outflows. On the other hand, if you have more liquid assets and can just about survive even if B fails, then B's failure will damage you, but will not spread further and damage your creditors.

Netting under a master agreement is different providing the counterparty can only make net collateral calls on you - allowing "notional inflows" in that scenario does not affect the objective of systematic stability.

Have I overlooked something?

Economics of Contempt said...

I see your point, and that could be the Basel Committee's intent. I can't claim any inside knowledge of the Basel Committee's deliberations on this point.

But if that's the reasoning, then why allow any cash inflows at all? I suppose you could argue that counterparties are more likely to make scheduled payments (i.e., coupon payments, derivatives payables) because they knew those payments were coming for a while, and likely have the money set aside, whereas margin calls from valuation changes on derivatives are by their nature unforseeable, sudden demands on counterparties' cash.

But then why are net inflows due to valuation changes on derivatives subject to a master netting agreement more reliable than similar inflows on derivatives not subject to a master netting agreement?

If a counterparty refuses to post, say, $100mm in collateral to a dealer on a derivative that's not subject to a master netting agreement -- perhaps because it doesn't agree with the dealer's mark (by far the most common reason) -- then the counterparty would also dispute the dealer's mark on a derivative that is subject to a master netting agreement. That would affect the netting calculation, and the dealer would receive $100mm less in net inflows (or would have to pay $100mm less in net outflows). The effect is exactly the same whether the derivative is subject to a master netting agreement or not. So why the (very) disparate treatment?

I guess we'll find out the US regulators' views on this when they start issuing proposed rules for Basel III (mid-2012, I believe?).

Anonymous said...

Netting doesn't improve the scenario if the reason is non-agreement on the mark, but it does if the reason is that the counterparty is insolvent.

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