Review of 2012: Basel III starts to bite

Capital and liquidity consumption now comes with a cost, and that started to make itself felt this year. Risk staff look back at a selection of the year’s big stories

On the face of it, there is not much to link JP Morgan’s credit trading losses with UBS’s decision to exit fixed income, nor to link either of those issues to the rise of swap futures contracts. But there is a common denominator – Basel III. The rules slap a higher price tag on the consumption of capital and liquidity, and began to dramatically reshape banks, markets and products this year.

In 2013, banks have a lot more work to do in terms of balancing funding and capital consumption against revenue generation, but many decisions depend on the details of still-outstanding rules, and as the regulatory process nears the finish line, it seems to be getting messier. Thorny issues relating to harmonisation and co-ordination need to be resolved.

RWA MITIGATION
Banks are racing to comply with the Basel III rules before they come into force, which means rapid and dramatic reshaping of the most capital-intensive businesses – primarily securitised products, credit and fixed income more generally. Long-dated, uncollateralised trades will produce much higher risk-weighted asset (RWA) numbers – against which capital is calculated – but banks are exploring a host of ways to mitigate the impact, and some have made significant inroads over the past 12 months.

The spotlight has been on the two big Swiss banks, which face added capital pressures as a result of the so-called ‘Swiss finish’. Credit Suisse pledged last year to halve the Basel III RWA level in its fixed-income division – and its co-head of global securities, Gaël de Boissard, spoke to Risk in June about the progress it was making. UBS took the opposite approach, announcing at the end of October that it would exit fixed income. Its head of investment banking market risk explained why at Risk’s US conference in New York in November – in short, the bank was not making enough money to justify the capital consumption, and lacked the pricing power to make the business work.

“This work – of evolving the business and reducing risk – has certainly been challenging. It has had an impact on the type of business we want to compete for, but we believe this is the right strategy for the bank”
Gael de Boissard, co-head of global securities, Credit Suisse
(Risk July 2012, pages 24–27)

“I would say across most fixed-income books, including credit, you’ll find that 80% of trades produce an acceptable RWA-consumption figure. The question is what to do with the other 20%”
Niall Cameron, global head of credit trading, HSBC
(Risk25 July 2012, pages 10–14)

“Your price of beef has tripled, your cheese is four times as expensive, your roll is twice as expensive, but you’ve still got to sell a 99-cent value meal. It’s a tough business”
Oliver Jakob, head of market risk for investment banking, UBS (see page 12)

THE LONDON WHALE
When JP Morgan announced a $2 billion trading loss on May 10, it sparked a host of questions. One early focus was a faulty value-at-risk model that roughly halved the reported exposure in the bank’s chief investment office (CIO). Queries followed about whether the model change had been approved by the relevant supervisor, in this case the Office of the Comptroller of the Currency.

Soon, attention switched to the make-up of JP Morgan’s board-level risk committee, which contained a notable lack of banking or risk expertise. In that respect, at least, the bank was not alone – analysis by Risk showed only four of the 73 board risk committee members at the biggest dealers have a risk management background.

But arguably the most important question was why the CIO changed a successful hedging strategy. JP Morgan’s chief executive, Jamie Dimon, provided an answer of sorts at a Senate committee hearing in mid-June – the unit had been told to reduce its RWA consumption. An article in Risk’s October issue added the missing detail: how the comprehensive risk measure in Basel 2.5’s trading book rules could bloat RWAs, and how a loophole in the rule might have allowed JP Morgan to reduce the unit’s capital consumption while piling up market risk. Those same dynamics could lead other banks astray, some experts warned.

“The cynical view is that the guys putting on trades figure out the weaknesses in the new VAR model, and put on positions that do not result in increased modelled risks”
Christopher Finger, executive director, MSCI
(Risk June 2012, page 6)

“The OCC doesn’t validate every specific model, it validates the framework by which the institutions construct and validate their own models”
Jeff Brown, managing director, Promontory Financial Group
(Risk June 2012, page 7)

“That can’t be the risk committee. Are you sure? You’re not missing a couple of people? That’s extraordinary. It’s just completely extraordinary. I’m speechless”
Former chief risk officer
(Risk July 2012, pages 39–45)

“There is a danger that banks shift from controlling risk to controlling RWAs. They are not the same thing”
Alistair McLeod, head of portfolio analytics, Barclays
(Risk October 2012, pages 23–26)

VAR – WHAT IS IT GOOD FOR?
After 18 years as the metric on which market risk capital is based, VAR could be on the way out – the Basel Committee on Banking Supervision proposed replacing it with expected shortfall when it published its long-awaited fundamental review of trading book rules in May. Three months earlier, Risk broke the news that the committee was considering killing off VAR and canvassed opinion from risk management experts, many of whom felt the metric’s shortcomings were either overstated, or were outweighed by the advantage of simplicity.

Your price of beef has tripled, your cheese is four times as expensive, your roll is twice as expensive, but you’ve still got to sell a 99-cent value meal. It’s a tough business

The review also suggested that banks with regulatory approval to model their market risk capital requirements should be required to calculate capital using the standardised approach – and might also have to use some percentage of the standardised number as a capital floor. That idea infuriated quants and risk managers and has been seen as further evidence of supervisors’ loss of faith in internal models – a phenomenon familiar to banks in Sweden and the UK, where regulators are clamping down on modelling freedom.

“If regulators swap VAR for expected shortfall it would make things worse”
Aaron Brown, chief risk officer, AQR Capital Management
(www.risk.net/2154611)

“There wasn’t one single watershed moment, but we spent a lot of time in the review process looking at what had gone wrong in the crisis. Risk was not being properly captured by the models, particularly around structured credit, so this led quite naturally to the proposal to reduce the reliance on them”
Alan Adkins, head of department, prudential policy division, UK Financial Services Authority (Risk July 2012, pages 16–20)

“This isn’t a recalibration – this is the abandonment of the internal model concept”
Head of quantitative research at one UK bank
(Risk July 2012, pages 16–20)

“If you put in either a floor or a multiplier, you don’t create the right incentives. It doesn’t matter what risk you really have – it’s a bureaucratic decision, and that is wrong”
Christian Clausen, chief executive, Nordea
(Risk August 2012, pages 25–28)

“For all our sovereign exposures we would anticipate an RWA increase of a few billion. It’s not the world’s biggest number, but UK government exposures don’t pay the biggest returns, so it does raise the question of whether the returns are enough to justify the RWA consumption”
A capital expert at a UK bank
(Risk November 2012, page 7)

DOWNGRADES AND COLLATERAL
The fine detail of structured finance ratings criteria became a hot topic in May, when a country-by-country review of European banks by Moody’s Investors Service reached Italy and Spain, resulting in mass downgrades. Sliding ratings meant many banks were also disqualified from acting as swap counterparties to more than 300 structured finance deals, having dropped below the second of two ratings thresholds. As a result, the swap provider had to post extra collateral – on top of what had been posted when the first threshold was breached – and either find a guarantor, or pay a replacement to step into the trade.

That should have been the trigger for international banks to ride to the rescue, but a month later Moody’s downgraded 15 of the world’s big dealers, leaving many of them close to breaching the triggers themselves. One solution, which at least six banks are said to be considering, is to revive the concept of derivatives product companies (DPCs) – off-balance-sheet entities that fell out of favour in the first phase of the crisis.

Before the dealer downgrades, Risk wrote about what it could mean for UK utility companies, many of which are structured as whole business securitisations and use the same structured finance ratings criteria. If their pool of acceptable swap providers became too small, the companies could have been downgraded too – potentially losing their government-approved licences.

“The last thing we want is to be downgraded to below investment grade – that has huge implications”
Jane Pilcher, treasurer, Anglian Water
(Risk May 2012, pages 16–20)

“We are looking for replacement counterparties or guarantors to take our place or guarantee our position in the transaction”
Spokesperson, Santander (Risk September 2012, page 8)

“Leading up to the credit crisis, and then post crisis, we had seen a decline in demand for DPCs. But more recently, in the past six months, we started to receive enquiries both in the US and in Europe about our ability to rate DPCs”
Roger Merritt, analyst, Fitch Ratings (see pages 28–30)

BACK TO THE FUTURES
When CME Group announced in September that it would be launching an interest rate swap future, there were two surprises. First, that the three-month contract would deliver into a cleared over-the-counter swap at maturity and, second, that it was based on a patent filed in 2007 by Goldman Sachs – a fact revealed by Risk two days after the announcement.

Dealers have generally been resistant to swap futures as a concept because it would compete directly with the more lucrative OTC market. An earlier attempt by CME to get the product off the ground failed miserably, and Eris Exchange has been trying to sign up dealer market-makers since it launched its own version in September 2010 – so Goldman’s decision to license its intellectual property to CME was seen as a sign the tide had turned.

The question is how far the water will rise. A host of buy-side firms say they are willing to migrate some or all of their OTC swap volumes to the new futures product, but only if the contract is sufficiently liquid. In theory, it should gain traction – but then, so should the Eris contract. Both allow users to replicate the economics of an interest rate swap, without the regulatory baggage that now goes hand-in-hand with the OTC market. The same rationale was behind the decision by Atlanta-based Ice to convert cleared energy swaps into futures contracts by October 13. Futures are also margined using a one- or two-day holding period rather than the five-day period used for OTC products – although there is a growing debate about whether that is appropriate.

“We believe it’s going to be Eris doing a huge volume of this – but one thing we’ll say unequivocally is this market will trade in this more standardised way over the next two, three, five years – there’s just no question about it”
Neal Brady, chief executive, Eris Exchange (Risk25 July 2012, pages 40–41)

“The conclusion you have to draw is that dealer attitudes have flipped. I think the cost of trading cleared OTC swaps is now becoming real, and all of a sudden futures look like the least bad alternative”
Derivatives industry source (Risk October 2012, page 6)

“Ice and its customers have rejected swap regulation”
Mark Young, partner, Skadden, Arps, Slate, Meagher & Flom (www.risk.net/2208965)

“I asked her: ‘What do you think the difference is between a swap and a future?’, and she got really angry, calling it a stupid question, and saying everybody knows swaps are more risky. And I said: ‘With all due respect, they are very similar things, but are called different names and regulated in different ways”
Don Wilson, founder and chief executive, DRW Trading (Risk October 2012,
pages 34–38)

“The arbitrary semantic labelling of a financial contract as a future, cleared OTC or non-cleared OTC is blind to its underlying liquidity, and may bear no resemblance to the time required to exit the trade”
Dave Olsen, global head of OTC clearing, JP Morgan (see pages 23–25).

LIBOR
Things moved quickly after Barclays agreed to settle a US-UK investigation of Libor rigging at the bank. Within hours, class action lawyers were predicting they would secure payouts worth tens of billions of dollars for plaintiffs that alleged they had been harmed by banks’ attempts to manipulate the interest rate benchmark. Within days, Barclays’ chief executive and chief operating officer had stepped down.

Things have scarcely slowed down since. A UK government-commissioned review of Libor was published at the end of September, and called for the benchmark to be published only where it is verifiable by reference to actual transactions. That spells the end for fixings in five minor currencies and a host of tenors.

“Things have changed dramatically in the past two hours”
The co-lead counsel for one Libor class-action lawsuit (Risk July 2012, page 7)

“I’m very proud of the division of enforcement here that did a terrific job putting together a complex, multi-currency, multi-jurisdiction case”
Gary Gensler, chairman, CFTC (Risk25 July 2012, pages 57–59)

“I asked two major Canadian banks, two international banks that transact frequently in Canada and two buy-side firms if they had seen a trade in Canadian dollar Libor in their significant experience. Nobody had seen one in the past five years”
Shahen Mirakian, derivatives lawyer, McMillan (Risk November 2012, page 41)

FVA
When John Hull and Alan White – finance professors at the University of Toronto – wrote an article on funding valuation adjustment (FVA) for Risk’s twenty-fifth anniversary issue, they knew it would put them at odds with the majority of derivatives practitioners. FVA should not be included in derivatives prices, they argued, because it results in bad trading decisions. As they later wrote in a response to the furore their argument generated, they appeared to touch a nerve.

“The message of this article is simple, although it is not one most practitioners readily accept. The apparent excess funding cost the derivatives desk faces should not be considered when a trading decision is made”
John Hull, Alan White, finance professors, University of Toronto (Risk25 July 2012, pages 83–85)

“That’s insane. They have totally lost the plot”
A senior European banker (Risk September 2012, pages 18–22)

“They’re clinging to an outmoded dogma that no longer reflects reality. It may have been reasonable when banks could fund at Libor. But now a desk will be charged a spread by its treasury like any other part of the business – and to cover that, they have to incorporate the cost into the price to the client. How else can they recoup it?”
Moorad Choudhry, corporate banking treasurer, RBS (Risk September 2012, pages 18–22)

“We have been inundated with responses from practitioners all over the world, on both sides of the argument. It seems that, without intending to, we have touched a nerve”
Hull and White (Risk October 2012, page 52)

‘MANY HAPPY RISK-ADJUSTED RETURNS’
Risk celebrated its twenty-fifth anniversary with a special issue, published in July. The aim was to shed some light on the future of derivatives and risk management. Feature articles explored topics that ranged from the regulatory constraints on cross-currency swaps – and what that means for firms that use international debt capital markets – to the challenges facing quantitative finance. And there were 20 interviews with leading lights from the banking industry, from exchanges and clearing houses, buy-side firms, regulators and others.

“If Basel III comes in and the impact on us is even worse than it is now, I envisage using cross-currency swaps would become very, very expensive for us or maybe even impossible”
Pedro Madeira, assistant treasurer, BAA Airports (Risk25 July 2012, pages 4–8)

“The whole industry needs realignment, between product design and clients’ needs, for instance. But for quants, it’s the need to realign the models with hard reality”
Bruno Dupire, head of quantitative research, Bloomberg (Risk25 July 2012, pages 73–77)

“It’s much harder to be all things to all people”
Colin Fan, co-head of corporate banking and securities, Deutsche Bank (Risk25 July 2012, pages 29–30)

“Dealers have very aggressively lobbied to slow the implementation of Dodd-Frank, and I applaud our regulators for continuing to march forward. We need to stop finding excuses to say no, and get the job done”
Kenneth Griffin, founder and chief executive, Citadel (Risk25 July 2012, pages 32–33)

“As we solve the too-big-to-fail problem in banking – which we are determined to do – we will not allow ourselves to create the tragedy of CCPs becoming too big to fail”
Paul Tucker, deputy governor, Bank of England (Risk25 July 2012, pages 60–62)

CLEARING CONCERNS
If current regulatory schedules hold – a big if, obviously – mandatory clearing will take effect next year. But it still doesn’t feel as though the industry is ready, as a number of this year’s stories illustrated. The year started with the fall-out from UK prime minister David Cameron’s decision to veto a proposed European Union treaty change. In part, that was a protest over the European Central Bank’s location policy, which states that clearing of euro-denominated products should only take place in eurozone-based central counterparties (CCPs) – a policy that threatens London-based LCH.Clearnet.

Central banks are trying to find a workaround, said Paul Tucker, the Bank of England deputy governor, in an interview that appeared in Risk’s twenty-fifth anniversary issue. But if that issue is resolved – and little else has been said publicly – plenty of others blew up this year. European rules on indirect clearing were one trouble-spot, raising questions about capital requirements for this untested business – and there is also no clarity on whether it will provide access to CCPs for the hundreds of firms that may struggle to find a clearing member.

Then, in early October, a rereading of the phase-in timeline for the CFTC’s clearing mandate provoked panic when lawyers and lobbyists started warning that it might not mean what the industry had initially thought. After a few weeks of panicked queries, the CFTC reassured the market that it would not need to rework its compliance plans.

And Risk reveals this month that the margin methodology for interest rate swaps at LCH.Clearnet’s SwapClear has become a subject for concern among the CCP’s member firms – some believe it needs to change the balance between initial margin and default fund contributions. Regulators are now vetting a revised model.

“The prime minister was right to make this a key demand. We need to keep markets open, not watch them closed by protectionists”
John Redwood, Conservative member of parliament (Risk January 2012, pages 14-18)

“Central banks are exploring how they can ensure there are no technical obstacles to lending. That doesn’t mean they have any duty or commitment to lend – just that there are no obstacles to it”
Paul Tucker, deputy governor, Bank of England (Risk25 July 2012, pages 60-62)

“We want to set up two [clearing] agreements, but I think it will be difficult. I am hopeful but also concerned”
Harald Frodl, head of middle-office management, Raiffeisen Capital Management (Risk September 2012, pages 26–28)

“If we had been given a mandate to develop capital requirements then we would have done, but we don’t have that mandate”
Tom Springbett, manager of OTC derivatives and post-trade policy at the UK Financial Services Authority and chair of an Esma task force on indirect clearing (Risk October 2012, pages 28–30)

“Frankly, there’s so much paper coming out the CFTC building that people sometimes think they understand what’s happening based on what they’ve been told, and they don’t actually go and read the words on the page. Somebody eventually did that and said, ‘Hey, wait a minute, this isn’t what I thought it said’”
Senior figure at an advisory firm
(Risk November 2012, page 10)

“Once we discovered this, we alerted LCH.Clearnet instantly and asked them to fix their models immediately because the deficiency leaves us exposed to higher mutualised losses”
A clearing specialist at a US bank (see page 8)

FRANKFURT VS CHICAGO
It’s almost a decade since Eurex filed a lawsuit against CME Group, alleging its hopes of competing in the market for interest rate futures – via a new subsidiary, USFE – had been squashed illegally. In August, one of Eurex’s charges was allowed to proceed, and Risk’s October cover story looked at the brief, bitter struggle between the exchanges, with help from a number of figures that were involved at the time. It turned into one of the most interesting, most colourful stories Risk has published.

“As I walked out of that dinner I was reminded of the film Little Big Man, in which Dustin Hoffman plays a muleteer who warns General Custer not to go into the Little Big Horn valley because a large Indian army lay waiting to ambush him. We were warning Eurex not to go into the valley – there were a lot of Indians down there”
Head of a large futures trading firm (Risk September 2012, pages 16–22)

“The Chicago exchanges were fighting for their lives and doing everything they could to delay things, so they could migrate trading on to electronic systems before the USFE launch”
Michael Gorham, director of the IIT Stuart Center for Financial Markets, Illinois Institute of Technology – and director of the division of market oversight at the CFTC when Eurex applied to launch its US exchange (Risk September 2012, pages 16–22)

“It was a giant stall, in which the CFTC became a barrier to entry. And Eurex only got its approval when its opportunity to succeed was lost. The longer the application was stalled, the less likely it was that Eurex was going to succeed. This is the kind of stuff you see on good TV shows”
Former senior CFTC staffer (Risk September 2012, pages 16–22)

TAXING TIMES
It was unfortunate timing. Soon after Michael Spencer, chief executive of Icap, was named on a list of major political donors to have dined with British prime minister, David Cameron, in February, the UK press spotted an interview with Risk in which Spencer said he had been told by a senior government figure that European proposals for a financial transaction tax would be vetoed by the UK. It was swept up in coverage of a supposed “cash-for-access” scandal, with newspapers including the Daily Mail and Independent putting two and two together to make five – only the Daily Telegraph pointed out that Spencer’s comments to Risk predated his dinner with Cameron.

“I have had it first-hand from very, very senior members of our administration who I know personally and have had good relations with for a long time, that it will be vetoed without any doubt and without any reservation at all”
Michael Spencer, chief executive, Icap
(Risk February 2012, pages 26–29)

EXTRATERRITORIALITY
It’s a bit long to be a buzz word, but extraterritoriality has rarely been far from the surface of the regulatory debate this year, and the industry’s fears took shape – albeit a shifting, ill-defined shape – when the CFTC published its guidelines on the cross-border application of its Dodd-Frank Act rule-makings in June.

In an interview that appeared in Risk’s twenty-fifth anniversary issue, the CFTC’s chairman, Gary Gensler, called the guidance “a very well-constructed document.” But industry lawyers, at least, did not agree – and Risk alerted both lawyers and regulators to one drafting error relating to the definition of a US person, prompting the CFTC to promise a fix.

“I think it’s a very well-constructed document, but we look forward to public comment – that always helps”
Gary Gensler, chairman, CFTC (Risk25 July 2012, pages 57–59)

“When you get down into the weeds, it is very confusing, internally inconsistent and not thought through with the level of precision it deserves given the nature of the subject matter”
Lenny Schwartz, partner, Davis Polk & Wardwell (Risk August 2012, pages 14–18)

“That language is incorrect. It shouldn’t be there. Thank you for identifying another problem – sorry about that. I’ll make sure that is amended”
A CFTC source (www.risk.net/2197749)