Banks tout break clauses as capital mitigant

Dealers say it was fair for regulators to have that view in the past, but insist it is time to revisit the subject. “A few years ago, you just wouldn’t exercise a break clause because it would kill the relationship you had with your counterparty. You would be lucky if they would ask you to quote on a swap again. But in today’s world, where funding and capital concerns are paramount from a dealer’s perspective, and where we are paying more attention to the economic cost of not exercising the break, counterparties are much more willing to have a rational conversation about break options. More and more of these options will be exercised in the future, purely because of these dynamics,” says one head of interest rate swaps trading at a European bank in London.

While no dealer was willing to provide hard numbers, most say there has been a noticeable increase in the number of break clauses exercised. However, they are still relatively few and far between.

Others say break clauses are also being used more frequently to put an end to swaps pricing disputes – themselves a more regular feature of the market since dealers recognised that discount rates depend on the type of collateral being posted in a trade, making it difficult to price and value swaps where counterparties have the option to post different types of collateral throughout the life of the transaction (see box, Working it out).

National regulators are not keen to comment, but they appear to have different policies. Switzerland’s regulator, the Eidgenössische Finanzmarktaufsicht (Finma), says banks are allowed to take break clauses into account for capital requirements under Basel II and III. According to the regulator, a 30-year swap with break clauses every five years could generate a different capital requirement from a 30-year swap without break clauses – although it declines to go into further detail.

Another European regulator says it agrees capital relief would be reasonable if there is a high probability that break clauses would be exercised. It also says it doesn’t know how the amount of relief would be calculated. The Basel Committee declined to comment on the issue.

Meanwhile, the UK Financial Services Authority (FSA) says the capital treatment depends on the exact structure of the swap, and is trade-specific. The FSA refused requests for further detail, saying it did not want to give an opinion on the treatment of break clauses for general publication.

There are different interpretations at the dealer level too. While most banks that spoke to Risk for this article say it is not currently possible to claim capital relief on break clauses, Citi says break options can reduce capital requirements.

“The rules on break clauses are silent and often the interpretation is left to individual firms. We determined that if you can prove the efficacy of optional termination clauses by employing a strict governance process, they do mitigate capital under Basel III,” says Henry Wayne, managing director of institutional clients group risk analytics for Europe at Citi in London – although he adds that the bank’s policy in under ongoing review. Asked for its take on the subject, Citi’s primary regulator, the US Federal Reserve Board, declined to comment.

While other banks appear not to be claiming capital benefit for break clauses currently, almost all say they are seriously exploring the issue, and intend to make the case to their respective regulators. In the absence of an agreed Basel Committee policy, they say treatment is likely to continue to differ from one country to the next.

“There is agreement on the Street that we need to look at break clauses more closely. But there is a lot of uncertainty around the issue. There is not going to be an objective and universal treatment. Banks and regulators will interpret these clauses differently. From a modelling and risk management perspective, we definitely consider the breaks to be real, so it would be perverse if we did not apply some sort of capital relief. It is something we will be discussing with our regulator, and I’m sure other banks will be doing the same,” says one counterparty risk specialist at a US bank.

But agreeing to recognise break clauses as a capital mitigant is just the first step. Banks and regulators would then need a way to reflect those clauses in capital calculations. Finma declines to detail its own thinking because the final CVA rules have yet to be finalised. It says the details of the precise treatment for break clauses are currently being hammered out between itself and the banks.