Basel output floors, VM rules and taper talk

The week on Risk.net, January 13-19, 2018

VM rules sound death knell for forex swaps in Europe

Market participants claim instrument was a “mythical creature” that never really existed

Revised Basel output floor could hit US banks after all

Fall in operational risk weights could push up capital requirements for market and credit risk

Taper talk drives wild swings in JSCC-LCH basis

Difference between pay-fixed yen swap rates at LCH and JSCC neared 16bp before falling 30% last week

 

COMMENTARY: Taking the floor

The expected impact of new Basel III calibrations is creating tremors around the globe, as output floors impinge on bank capital consumption.

First, US banks cannot assume that because they already comply with the floor on internal capital models – enforced by the US Collins Amendment to the Dodd-Frank Act – the new Basel floor will have no impact on their capital consumption.

A source at a US industry body has warned against being too complacent over what he calls “conventional wisdom”, adding that it may not be “magically true” that the 72.5% Basel output floor doesn’t matter to US banks – because it’s 72.5% of a larger numerator. “We are trying to figure out the maths and understand the impact,” he says.

European regulators suspected US enthusiasm for the Basel output floor – finalised on December 7 – was driven partly by competitive concerns among US firms that already face the Collins floor. The Collins Amendment, introduced in 2013, requires banks to hold enough capital for 100% of market and credit risk-weighted assets (RWAs), as calculated under the standardised approaches. But the floor excludes operational risk and credit valuation adjustments.

Crucial to the eventual impact on US banks is the change in the methodology for calculating operational RWAs, which was also included in the December 7 package. Since op risk is excluded entirely from the Collins floor, the amount of capital banks hold against it naturally offsets the 100% floor. Therefore, the larger the op risk RWAs as a share of the total, the lower the effective floor on credit and market RWAs.

The Basel rules agreed in December could also inflate the RWAs of Japan’s largest banks by as much as 30% and slash capital ratios, with exposure to unrated corporates the main culprit.

Under the new standardised approach, small unrated corporates – with annual consolidated sales of less than €50 million ($61 million) – will attract a risk weight of 85% under the standardised approach, while anything larger that does not have an external credit rating will attract a 100% risk weight. This will feed through to the standardised floor, limiting the benefits Japanese banks can obtain from internal models.

The changes will also reduce capital ratios, as banks have to hold more capital against the same assets. European lenders that rely heavily on internal models are set to be hit as well.

Last week, dealers claimed Basel’s final overhaul of credit valuation rules was too conservative. The framework offers two approaches: the easier but more punitive basic approach, and a standardised approach.

Some dealers’ emerging markets subsidiaries may have to use the basic approach – which has remained largely unchanged and is expected to increase capital by multiples – making it expensive to manage their corporate exposures. Banks also say the standardised approach contains overly conservative liquidity horizons and recognition of diversification.

STAT OF THE WEEK

In an unprecedented bout of volatility amid talk of a potential change to Japanese monetary policy, at one point last week the rate for a 20-year pay-fixed swap was nearly 16 basis points higher at LCH than at the Japan Securities Clearing Corporation, before falling 30% the following day.

QUOTE OF THE WEEK

“We came to realise at the end of 2016 that the forex swap is a sort of mythical creature” – senior manager at a UK-based currency management firm. Dealers and buy-side firms have effectively killed off foreign exchange swaps in Europe, thanks to new rules requiring the instruments to be collateralised. Market participants, however, argue forex swaps never really existed in the first place.

Further reading

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• Risk management

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• 16 Jan 2018