1. NSFR and FRTB address the causes of the financial crisis which triggered a costly recession: banks’ excessive reliance on short term funding and insufficient bank capital to face up market risk
A public authority representative stated that the FRTB and NSFR are significant components of the Basel Committee post crisis regulatory framework. They are designed to be global minimum requirements which member jurisdictions commit to apply and are two standards addressing two key fault lines of the pre crisis regulatory framework. In the absence or inconsistent implementation of global standards like the FRTB and NSFR, regulatory fragmentation and uneven playing fields will emerge.
A national authority representative outlined that the first point is liquidity; the two pieces of regulation are the regulatory response to what was fundamentally a bank liquidity crisis, impacting banks on both the funding and market sides of their balance sheets. Banking crises typically result in longer, deeper and costlier recessions.
The representative highlighted that the accumulation of liquidity in banks’ balance sheets relates to the core function of banks, to transform liquidity, and that was done with an excessive reliance on short term funding. At that time there was the belief that what is good for trading is good for the financial system and, by extension, for financial stability; however, that is not true. The fact was that banks held a lot of assets in their trading books that were considered highly liquid, but, when the crisis hit, the banks did not have enough capital to deal with the valuation losses that materialised.
Furthermore, the crisis revealed concerns about the valuation of complex securities issued by banks. There was then distrust among banks about pricing models. The new regulations seek to address these shortcomings.
1.1. The NSFR limits bank reliance on short term wholesale funding
A national authority representative stated that for the NSFR, the issue is to limit reliance on the short term wholesale funding and ensure that less liquid assets are funded by stable funding. There are important consequences. First, inter bank maturity transformation is penalised from one to six months, six months to one year, and above one year. Second, maturity transformation is allowed if it is funded by a non financial, meaning that there is no penalty on lending to banks for more than six months when it is funded by deposits. Third, the NSFR is neutral with respect to transformation between non banks, which is important because it keeps banks with their role of intermediation and financing the real economy.
1.2. The FRTB proposes more robust and risk sensitive approaches
A public authority representative explained that for the FRTB one of the most important achievements is to draw a clearer boundary between banking and the trading book. There is also an improvement of the standardised approach by way of having a more risk sensitive approach, although it is still conservative with respect to hedging and diversification. Also, there is an improvement of the internal model approach with a move from the VaR to the expected shortfall, which is a more robust approach in particular because it factors in tail risk distribution.
A national authority representative commented that, from a regulatory perspective, both the FRTB and NSFR work towards a more risk adequate framework and consequently a more resilient sector. From this national perspective, risk adequate frameworks and measures are appreciated, which is why there is some sympathy for anything that is more granular in measuring risk.
1.3. The two new regulations require defining appropriate trade offs
A public authority representative outlined that the new regulations introduce trade offs. First is a general trade off between liquidity and leverage. Attempts to limit leverage may impact liquidity. There is also a trade off between bank and systemic liquidity, which may be a problem. Finally, there is a trade off in the recognition of hedging, in particular CVA. When one has a trade off there, it is essentially a quantitative calibration issue, and discussion is helpful to strike the right balance.
2. Financial markets will benefit from more resilient banks but may be more limited in their ability to operate
A public authority representative stated that, from a regulatory perspective, the consequences of the FRTB and NSFR are quite different because they target different issues. From the market participants’ perspective, both the FRTB and the NSFR may be viewed as comparable subjects with respect to their potential market implications, but the real question is whether there will be significant responses in markets on the two standards. It is difficult to establish evidence in advance. On the contrary, the public authority representative pointed out that markets will benefit from more resilient banks and advised caution in combining those perspectives when reflecting on both standards in one discussion.
The primary goal of the international agreements was, and is, to establish adequate minimal requirements for the aforementioned risks; that is what the international fora are about. Banks should be able to cover the factual risk of all their business units, including those being addressed by the two standards. Thus, both regulatory propositions are valuable extensions of the regulatory framework. The representative outlined that any unsolved issues should be discussed but have to be tackled in a factual, objective and constructive manner.
The Chair noted that the difficulty of knowing in advance the impact the rules will have in the market is the problem behind the impact assessments that must be carried out in the EU.
3. The industry reports that certain aspects of the proposed frameworks fail to match the actual risk and short-term nature of certain EU specific bank market services, and products related to equity and fixed income markets
3.1. The NSFR ignores the short-term nature of synthetic financings of EU equity markets as well as its effective risk
An industry representative commented specifically on the equity financing market. The representative outlined that investors can finance their equity portfolio in a number of ways: they can do so through physical financing, otherwise known as debt financing; or they can choose synthetic financing where, rather than going out and directly purchasing equity, the investor enters a swap agreement with the counterparty whereby they receive the economics of owning the stock and in return pay a financing rate. The counterparty entered into the swap then goes out to the market, acquires the share and puts it in inventory as a hedge against that liability. In that manner, the counterparty has no market risk. There is a liability to the investor on the swap side, and a matched asset, which is the share that would be held in inventory against that. The swap is cancellable and the funding on that share in the inventory is overnight in nature, so they are close, if not identically matched.
As opposed to the US where the ratio is the opposite, the majority of European equity financing is conducted through synthetic financing, primarily due to client demand, which is driven by the greater complexity of the European market. The markets are differentiated from an access and settlement perspective, and so from an operational efficiency perspective clients find it useful to use synthetic instead of physical financing, and then allow the swap counterparty to worry about the operational machinations behind the scenes.
The issue with NSFR in this particular instance is that its current form does not allow recognition of the matched asset against the liability. Consequently, the asset has to be looked at on a standalone basis. Looking at it on a standalone basis, as an asset of the swap provider, requires the investor to apply RSF to that, and the percentages are significant for equities, at either 50% or 85%; they are very large numbers, depending upon the underlying character of the asset. That long term funding has to be applied, despite the fact that the transaction that the hedge underlies is very short term in nature. It is a pure short term equity funding transaction.
The impact could cause an increase of anything from doubling to tripling the financing cost on a synthetic basis. That has the potential for significant impact in the marketplace, and a decrease in liquidity. The representative does not advocate that recognition of the linked nature would exempt investors from a requirement of RSF, but advocates that, given the linked nature, 50% or 85% is too great, especially in light of the way the rules apply to other alternatives. Furthermore, the knock on effect of this goes across many investors.
3.2. The NSFR imposes over one year sterile funding to repo transactions, which fund cash fixed income markets and market-making which are very short term by nature
A banking industry representative explained that where banks like Credit Suisse provide finance predominantly around the equity business, the repo business tends to provide finance for the fixed income product on a more transactional basis. Thinking about the journey that the repo and cash markets have been on since macro prudential rules were put in place, leverage is the binding constraint.
When new rules come in, particularly NSFR, the first thing to consider is where there may be more leakage around more leverage requirements, or more capital required to support the leverage present in the business.
The NSFR is interesting because a lot of the available repo market data in Europe is from the ICMA surveys. The market is very short in nature, not because of irresponsibility of short term financing against long term assets, but simply due to the nature of the assets side of the balance sheet. The repo markets in Europe drive funding of the cash markets and market making of all of the banks. Those positions are essentially overnight. The other area for clients is using leverage within their strategies, which themselves are short in nature and linked.
The most flaring problem with the NSFR is that, based on the combination of the representative’s organisation’s funding within their books, they will create an NSFR requirement, so greater than one year funding. NSFR is designed to be a top of the house metric and very different from the LCR. If the representative’s organisation creates an NSFR event or has a deficit, the group treasury will raise those liabilities to meet the organisation’s ratios as an institution. If the positions are already funded and further liabilities are suddenly raised, the organisation has to generate HQLA against it, so will either go out and buy bonds to hold in their buffer, or will deposit the liabilities, which in itself leverages the institution again. The way it currently works, and should be best practice, is that all charges in a capital and cost basis get pushed down to the operating businesses so they can make the right decisions regarding pricing their book and what type of businesses to be in.
As a repo desk supporting both the firm and clients, there is a scenario where as they go through their activity they will potentially be utilising more capital to support leverage and increase the cost to the business they run. It is difficult to calculate, and is a conversation held with both local and international regulators. It is difficult to test a rule before implementation, but the representative anticipates that the NSFR will lead to 5 10% more leverage utilised; that is before getting into the quirks regarding linked transactions in repo.
3.3. FRTB is mainly perceived by the industry as an additional capital increase exercise, which could strongly impact financial markets
An industry representative did not think that the FRTB is fine. In principle, there is nothing about either rule that panel members from the private side object to as a matter of policy. Improving the design of the market risk rules is the right thing to do. One of the big lessons of the financial crisis was the necessity of having liquidity rules, and short term stress tests and structural rules. The principle is comfortably accepted.
The rules are very different and the issue is to consider them in the context in which they occur. Regarding the FRTB, it is important to keep in mind that the first big post crisis capital reform was Basel 2.5, where there was a dramatic and quickly engineered increase in market risk capital implemented very shortly after the crisis, at lightning speed relative historically to that at which the Basel Committee has moved.
The representative stressed the fact that the FRTB was intended to be a commitment on the part of the policymakers to revisit the market risk rules and refine them to deal with the problems that arose with the quickness with which the market risk rules were revised. He felt that the FRTB has since transformed from a refinement exercise into a capital increase exercise.
Describing the impacts of these rules is difficult, particularly before implementation. The assessments by the Basel Committee give market participants enough to give rise to significant worries that policymakers should have about the impact of both measures.
Regarding the FRTB, much of the analysis is done in the aggregate, looking at the impact that the FRTB has across a broad range of banks. However, the key issue with the FRTB is most pronounced with regard to the big market making banks. A rule like the FRTB applied across a broad swathe of the industry has the potential to result in misleading impacts in terms of desk level consequences as well as real commercial impacts.
Further, many of the impact assessments assume full model approval and the numbers indicate significant cliff effects between the standardised and modelled outcomes on the FRTB, which is a difficult dynamic to operate under.
4. Smaller financial markets such as Nordic forex or fixed income markets are specifically impacted
4.1. The proposed rules are particularly detrimental to the liquidity providers of the relatively small financial markets such as Nordic forex or fixed income markets
A representative of a large bank in the Nordic region outlined that the bank they represent is a globally systemic financial institution, so faces different challenges to other large universal players.
Governments and corporates fund themselves by issuing bonds. Mortgage buyers, to a large extent, finance their properties in banks or mortgage institutions that issue mortgage bonds. They are bought by pension funds and other institutions, who then hedge their commercial risk with derivatives. Banks in general are required to hold HQLAs for various risk management and regulatory reasons. These activities are dependent on the presence of liquid financial markets. In the Nordics, liquidity is dependent on banks’ willingness to act as intermediaries in the financial markets.
The Nordic markets are relatively small and largely outside of the EU. They have large corporate bond markets and a limited number of market participants. Consequently, a Nordic market making model has emerged where dealers manage supply and demand imbalances, find buyers and sellers, and transform and manage risk on behalf of clients. In essence, they provide market liquidity, which is the foundation for an efficient financial market.
Like other dealers or markets, the Nordics have observed shrinking dealer capacity and indications of declining market liquidity, to which a lot of the new regulation contributes, as well as accommodative monetary policies and high demand for HQLAs.
In terms of the policy objectives and overall framework designs of NSFR and FRTB, evidence in the Nordic markets suggest some changes to the current calibration are needed, although it is supported in essence. It seems to create more downward pressure on market liquidity. It is hard to see a scenario where the opposite would be the intent.
4.2. Non risk sensitive floors on internal models (FRTB) and overstated market and funding risks explain expected excessive capital increases which will be passed to end users or dry the liquidity of markets at the expense of financial stability
An industry representative outlined that the particular concerns with the FRTB and NSFR are mainly in the Nordic’s core markets, on products like HQLA government and corporate bonds, FX, and standard risk management products. In terms of resulting cost increases for end users, holdings of HQLA assets and corporate bonds are in large driven from an FRTB perspective by the non risk sensitive floor on the internal model and seem an overstatement of the credit spread risk for corporate bonds. Furthermore, being non EU currency sensitive, the treatment of non EU currencies is a challenge, and that is seen in calculations, particularly on FRTB.
Overstating the market and funding risk would unnecessarily increase capital and funding costs for banks. They will require changes in the composition, size and absolute levels of liquidity provisions.
From the private sector side, there is more to financial stability. From a positive side, the Nordics could be considered a positive outline in terms of capitalised levels, for the time being at least. It also came through the crisis in relatively good shape. The lack of dealer capacity could lead to new systemic risks and contribute to other forms of instability in the markets.
Furthermore, on proportionality, some of the issues are not just in terms of size, but more in terms of implementation and the impact of the calibration. In particular with corporate bonds, FRTB affects the effective transmission mechanism from the consumer to the capital markets. Calibration, or the lack thereof, would incur an average estimate of two and a half to four times capital increase on their market increase. The industry standard is closer to one and a half to two and a half times. Those measures are challenged by the fact that there are specificities in the Nordic markets that are slightly different compared to being a universal bank.
5. Key challenges associated with the implementation of the standards
5.1. Data quality and data management is essential
A public authority representative outlined for banks, the main challenges should concern data quality and data management in order to allow for a timely adoption. The focus should not be therefore only on capital and liquidity: processes and control, IT and data will also require from banks further development work. In principle, whatever the EU and the Commission decide on, it should not be decided one sidedly.
The EU has to ensure that they have international agreements that are implemented and work everywhere. As desirable as the measures may be, since they lead to more resilient markets, the EU may have to ensure that they do not implement something that is not implemented in other large jurisdictions.
5.2. The global commitment to the proposed rules is viewed as uncertain
An industry representative stated that the question is implicitly whether Europe has made a mistake in moving forward with implementation at a point where global commitment to the rules is uncertain because of changes in the US and other jurisdictions. Although the private sector wants consistency, they primarily want the rules designed in a way that is functional and does not have adverse impacts. Caution is urged in that regard.
A public authority representative advised that consistent implementation of the standards must be ensured, or at least promoted, and rules clarified where possible.
5.3. The actual impact is being closely monitored and potential unintended consequences will be addressed
A public authority representative explained that it was recognised that the starting point was very low and the crisis demonstrated that market risk was not supported by an appropriate level of capital, even after the Basel 2.5 quick fix, as designed by the Committee.
Regarding the FRTB, the Basel Committee recently published its latest Basel III monitoring exercise, which shows that the percentage increase of market risk minimum requirements would be significant. However, a number of elements should be noted:
• Banks have not yet implemented the FRTB. Some have reported data based on the standardised approach for desks that will become subject to an internal model approach, which is important because the standardised approach appears to be the main driver for an increase in capital requirements, so it is likely that the final numbers will be lower than the current estimate.
• No assumptions were made about behavioural response. Evidence from previous reforms, including Basel 2.5, indicates that banks have progressively adjusted their overall trading book position or strategy.
•Even a significant increase in market risk capital requirements does not necessarily mean an increase in overall minimum required capital. As of today, all participating banks to the Basel Committee’s exercise meet the minimum target risk weighted requirements.
The impact must be closely monitored and potential unintended consequences and complexity addressed where possible.
In response to the request for more clarity or adjustment to the rules, during the implementation period of both the FRTB and NSFR standard, the Basel Committee will continue to monitor the standards’ impacts on behaviour. If the evidence suggests unintended consequences then the Committee will address them and, if needed, will re-examine parameters or provisions. That is just part of the Basel Committee’s usual process.
When the FRTB was published, it was acknowledged that further work remained to ensure appropriate calibration or clarify provisions. When the NSFR was adopted by the governors and heads of supervision, there was an agreement to conduct an observation phase, and that any unintended consequence would be addressed before finalising and implementing the NSFR in 2008.
Currently the Committee is looking at issues raised by stakeholders and based on the figures, as observed in the Basel III monitoring exercise. Under the FRTB, they are looking further at the P&L attribution test and the treatment of some risk parameters or activities, especially the treatment of ethics risk under the standardised approach. Regarding NSFR, they are looking further at the treatment of derivatives. That is part of their process.
6. It is still difficult to anticipate US regulatory directions and whether they will contribute to international regulatory consistency
Regarding the EU versus US implementation status of the standards, a public authority representative emphasises that the EU and US have different rule making processes, so rules are not always proposed at the same time. The US has proposed the NSFR, but not the FRTB. However, that is also the case for the vast majority of Basel Committee members. It means that the EU Commission is well ahead in terms of the process.
Implementation is due in 2019. The Basel Committee, as a process to monitor the timely and consistent implementation of the standards, will include the FRTB and NSFR in the scope of its assessments under its Regulatory Consistency Assessment Programme (RCAP). In due course the implementation of the standards across jurisdictions will be then reviewed and the materiality of observed deviations will be assessed. The representative understands the doubt around the different timing in terms of implementation, but thinks that overall it is premature to form any firm judgment. He also noted that, in the EU proposal, the proposed rules would be phased-in for a period of three years from the implementation date agreed by the Basel Committee.
An industry representative stated that the public policy representatives in Washington have indicated that under the current administration it is difficult to project whether there will be completion in any foreseeable time period, thus a lot of stasis will enter the US market.
A banking industry representative suggested that nobody really knows the answer. The Administration itself, understandably, does not know. The regulatory decisions will be made by the appointments that the US makes to the key positions that will drive those decisions.
Notably, the executive order issued by the administration on regulations is no different from the call for evidence and some of the efforts that Europe has undertaken as a way to assess the impact of regulation. How that will manifest in terms of real policy changes is not yet clear, but one interesting data point observed at Credit Suisse was the result of the communique that came from the G20 finance ministers’ meeting. There, a lot of attention is paid to the language on trade, but the language on financial regulation was essentially copied from previous communique language. One important data point is whether the G20 communique statement is an accurate reflection of where the administration is. There are a lot of mixed messages, and nobody really knows the answer.
A public authority representative stated that, since Germany currently has the G20 presidency, in Baden Baden, the representative would interpret the communique differently. There was very little intervention, if any, from the US to the question of the financial markets and regulation. The representative advises that nobody over interpret the communique not changing. Whilst nobody knows what will happen in the US, the market has to await the US’s decision and who will represent the US in the Fed board.