Brexit may have overshadowed events over the past month, but it doesn’t mean everything else has just stopped. A huge amount of work is ongoing, from preparations for forthcoming margining requirements to flagging new straight-through processing rules. The capital space has been particularly busy with nine consultation responses filed in a matter of weeks, covering topics from internal models to the net stable funding ratio.
Our response to the Basel Committee on Banking Supervision’s consultation on the leverage ratio was one of the most recent. In it, we reiterate our concern about the impact of the leverage ratio on client clearing. This is an important topic, not least because the Group-of-20 specifically wants to encourage more clearing.
At its heart, the issue is fairly simple: we believe segregated initial margin posted by clients is not a source of leverage for banks, as it cannot be used to fund their operations. Rather, it is meant to cover any losses by a defaulting client – in other words, client initial margin is intended to reduce the exposure related to a bank’s clearing business. Despite this, the leverage ratio doesn’t currently recognize this exposure-reducing effect, which means the capital required to support this business is unnecessarily high. This makes the economics of client clearing more challenging for clearing-member banks.
Importantly, the Basel Committee said when launching its consultation in April that it would collect data to study the impact on client clearing – a step we welcome. ISDA has already pulled together some preliminary information, which indicates that not recognizing client initial margin has a significant effect on the leverage ratio exposure of client cleared transactions. This data will be further developed and submitted to the Basel Committee.
But it’s not just cleared transactions that are affected by this. A similar argument applies to bilateral non-cleared trades: segregated initial margin posted by customers should mitigate exposure, as it is intended to cover the losses racked up by a defaulting counterparty.
ISDA supplied data on this segment too, in response to a request from the Basel Committee for information on bilateral derivatives with counterparties. This issue will become increasingly important – and will have an increasingly large impact on capital requirements – as margining rules for non-cleared derivatives are rolled out.
Under those rules, initial margin has to be segregated and – like collateral posted for cleared transactions – cannot be used by a bank as a source of leverage. Exact requirements differ from jurisdiction to jurisdiction, but they all strengthen the protection given to initial margin, and ensure it is segregated from the margin collector’s proprietary assets. For example, under final margin rules published by the US Commodity Futures Trading Commission, initial margin must be held by a third-party custodian to ensure it is available to the non-defaulting entity in the event of a counterparty default. The custodian – which cannot be affiliated to either counterparty – cannot rehypothecate the margin.
Given this margin cannot be used as a source of leverage, and is intended to mitigate exposure, we believe initial margin received should be recognized as exposure-reducing in the leverage ratio calculation.
We very much welcome the fact the Basel Committee has reopened the leverage ratio for consultation – that kind of flexibility is important when regulators are implementing new rules virtually from scratch. We hope the points we raise will be considered and that the leverage ratio is made stronger as a result.