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New Financial Regulations, Implementation of Basel III, and Debt Management: Conceptual Issues

Cristina Pailhé

IFD/CMF Consultant

10th Annual Meeting LAC Debt Group

Asunción, Paraguay

11-13 August 2014

Background

• The international financial crisis motivated a significant set of reforms:

1

•To correct the weaknesses that led to the global crisis

2

•To build safer, more resilient sources of finance to serve better the needs of the real economy

•These reforms have direct and indirect, intended and/or unintended consequences on sovereign risk and sovereign debt management, pricing and demand.

• Complacent pricing and accumulation of sovereign risk up to 2009 by banks. Market led phenomenon (H. Hannon, BIS, 2013)

• Banks engage in ‘carry-trade’ investment strategies incentivized by the current treatment in capital requirements

• Regulation provide incentives for banks to accumulate too large sovereign exposures.

• ‘financial repression’

• captive investor base

• Highly rated sovereigns are low-risk but they are no longer perceived as risk-free

• Since the bank bailouts, sovereign and banking default risks as closely intertwined

Background

Are these risk recognized and captured by current capital/regulatory requirements?

What are the implications for sovereign debt markets?

Some of the regulations affecting sovereign debt markets

• Basel II, Basel II.5 and Basel III:

• Capital requirements

• Leverage ratio

• Liquidity ratios: liquidity coverage ratio (LCR) and net stable funding ratio (NSFR)

• Regulations encouraging OTC derivatives to be moved towards central counterparties (CCPs) and trading platforms.

• The implementation the Dodd-Frank Act in the US, and Capital Requirement Directive IV in the EU

Basel III

• Comprehensive set of prudential rules developed by the BCBS after the financial crisis.

• It raises the resilience of the banking sector by strengthening the regulatory capital framework, building on the three pillars of the Basel II framework.

• A new definition of capital • Capital buffers • Liquidity ratios • A leverage ratio • An enhancing of risk coverage

Basel III includes

• Published in December 2010, and progressively completed and complemented.

Basel II: capital requirements

• Basel II is still the standard to calculate minimum regulatory capital. Is has not changed under Basel III.

For credit risk:

Standardized Approach (SA). Reliant on ratings from Credit Rating Agencies

Internal Ratings-Based (IRB) approach – (Foundational or Advanced). Based on banks’ internal credit ratings

• Pillar 1 requirements are complemented with supervisory review (Pillar 2) and banks’ disclosures requirements (Pillar 3).

Pillar 1: establishes the minimum regulatory capital to cover credit, operational and market risks

Basel II: Standardized Approach for credit risk

• Under the SA sovereign exposures in the banking book are risk weighted according to their external rating.

Credit assessment

AAA to AA- A+ to A– BBB+ to BBB–

BB+ to B– Below B– Unrated

Risk weight 0% 20% 50% 100% 150% 100%

Capital requirement

0% 1.6% 4% 8% 12% 8%

• National discretion: lower risk weight (eventually 0%) to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency.

• The case of the EU and several LATAM countries

Basel II: Internal Ratings-Based Approach for Credit Risk Sovereigns

Illustrative IRB capital charge for sovereigns (%)

Probability of default Risk weight Capital charge

0.01 7.53 0.60

0.02 11.32 0.91

0.05 19.65 1.57

0.10 29.65 2.37

0.25 49.47 3.96

0.50 69.61 5.57

0.75 82.78 6.62

1.00 92.32 7.39

2.00 114.86 9.19

3.00 128.44 10.28

4.00 139.58 11.17

5.00 149.86 11.99

6.00 159.61 12.77

10.00 193.09 15.45

20.00 238.23 19.06

• Using a Basel formula, inputs (PDs, LGDs, M) are converted into risk weights and regulatory capital requirements.

• Treating a significant portion of sovereign exposure as risk-free contradicts the granularity required for a meaningful differentiation of risk.

• There is no floor for the PD as for corporate and bank exposures (3-basis points)

Assumes LGD of 45% and maturity (M) 2.5 years. Source: BCBC and H. Hannoun (2013)

Basel II: IRB risk weights for sovereigns

• IRB can produce some risk differentiation by assessing individual sovereign exposures and getting more granular estimates

• Very low capital charges for advanced economies sovereign portfolios => differentiation quite immaterial in practice.

• Very low default frequency observed in advanced economies and limitations in the risk-weighting mechanism.

=> Some IRB estimates are not so different from the SA in practice.

• Tend to rely on external ratings as a reference point.

Basel II.5: capital charge in the trading book

• Introduces an Incremental Risk Charge (IRC):

• capture losses due to both default and credit rating migrations for all trading positions, including government exposures.

• banks need to measure and hold capital against both risks, that are incremental to the specific risk captured in VaR models.

• it was incorporated in response to the increasing amount of exposure in banks’ trading books to credit-risk related products whose risk was not properly reflected in VaR.

• Limit incentives to hold assets in the trading book vs. the banking book

• Higher capital charges for securitized assets in the trading book

Basel II: Pillar II and sovereign risk

• Risks not fully captured by Pillar I might be addressed by Pillar II.

• Supervisors could consider specific measures, e.g. when credit and concentration risk are deteriorating and exceeding manageable levels:

• interaction with the bank; e.g. dialogue with senior management

• most intrusive or preventive actions; eg. adjustment of valuations

• applying a specific provisioning policy to the assets

• requiring to strengthen its capital base.

Basel III: Leverage ratio

• Banks should hold a minimum of eligible capital of their stock of non-risk-weighted assets.

• Reporting to national supervisors as from 1 January 2013. Public disclosure starting 1 January 2015. Final calibration completed by 2017. Migration to a Pillar 1 treatment on 1 January 2018.

LR Objectives:

Constrain the build-up of leverage in the banking sector

Reinforce the risk based requirements with a simple, non-risk based “backstop” measure

Helping avoid destabilizing deleveraging processes which can damage the financial system and the economy

• Leverage Ratio =𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑀𝑒𝑎𝑠𝑢𝑟𝑒

𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑀𝑒𝑎𝑠𝑢𝑟𝑒≥ 3%

Basel III: Leverage ratio

Capital Measure: Tier I capital

Exposure measure: on-balance sheet exposures;

derivative exposures; securities financing transaction (SFT);

off-balance sheet (OBS) items.

Basel III: Leverage ratio and sovereigns

• Sovereign debt fully included in the exposure measure.

• The LR has the potential to act as a quantity-based constraint to the amount of sovereign debt banks hold.

• It is a disincentive for banks holding low-yield sovereign debt

• It is a significant constraint for banks with important trading operations.

• The LR is a disincentive for banks to engage in activities that are low-margin and balance sheet intensive => impact on sovereign repo.

Basel III: Liquidity requirements Liquidity Coverage Ratio (LCR)

LCR = 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 ℎ𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑳𝒆𝒗𝒆𝒍 𝟏+𝑳𝒆𝒗𝒆𝒍 𝟐)

𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 30 𝑐𝑎𝑙𝑒𝑛𝑑𝑎𝑟 𝑑𝑎𝑦𝑠 ≥ 100%

Level 1

Cash, coins, central bank reserves, high rated securities issued or guaranteed by the sovereign or central bank (in domestic currency if sovereign has non 0% risk weight, otherwise subject to limits). No limits.

Level 2

Securities issued or guaranteed by sovereigns, central banks, PSEs or multilateral development banks with 20% risk weight; corporate debt securities and covered bonds; residential mortgage backed securities; common equity shares. All must meet specified conditions. Limited to 40% of the overall stock of liquid assets.

The LCR will be introduced on 1 January 2015. The minimum requirement will be set at 60% and rise in equal annual steps to reach 100% on 1 January 2019.

• No limits on HQLA means the whole buffer could consist of government bonds

• Safe assets are hoarded

• Sovereign rated below AA- threshold are still eligible as Level 1.

• Highly rated corporate and covered bonds qualify as Level 2, albeit subject to limits.

• The BCBS quantitative impact study found that banks currently hold Level 2 assets amounting to well below 40% of their total liquid assets.

• Banks can diversify their liquidity buffers globally

• These are higher-yielding assets

Banks will demand more sovereign assets

Basel III: LCR Effects on sovereign assets

Demand from other (liquid) assets will also increase

• No limits on HQLA means the whole buffer could consist of government bonds

• Safe assets are hoarded

• Sovereign rated below AA- threshold are still eligible as Level 1.

• Highly rated corporate and covered bonds qualify as Level 2, albeit subject to limits.

• The BCBS quantitative impact study found that banks currently hold Level 2 assets amounting to well below 40% of their total liquid assets.

• Banks can diversify their liquidity buffers globally

• These are higher-yielding assets

Banks will demand more sovereign assets

Demand from other (liquid) assets will also increase

• Banks have to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.

NSFR = 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 (𝐴𝑆𝐹)

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 (𝑅𝑆𝐹)≥ 100%

Basel III: Liquidity requirements Net Stable Funding Ratio (NSFR)

ASF

The portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR (one year).

RSF

It is a function of the liquidity characteristics and residual maturities of the assets and off-balance sheet (OBS) exposures held by the institution.

• The NSFR is not fully completed yet. NSFR, including any revisions, will become a minimum standard by 1 January 2018.

NSFR: Capital and liability categories and associated ASF factors

ASF factor Components of ASF category

100%

• Total regulatory capital

• Other capital instruments and liabilities with effective residual maturity ≥ 1 year

95% • Demand and term deposits with residual maturity ≤1 year, from retail and SME customers

90% • Less stable non-maturity deposits and term deposits maturity <1, from retail and SME customers

50%

• Funding with residual maturity <1 provided by non-financial corporate customers

• Operational deposits

• Funding with residual maturity <1 year from sovereigns, public sector entities (PSEs), and multilateral and national development banks

• Other funding with residual maturity ≥6 months and < 1 year not included in the above categories, including funding provided by central banks and financial institutions

0%

• All other liabilities and equity not included in above categories, including liabilities without a stated maturity

• Derivatives payable net of derivatives receivable if payables are greater than receivables

NSFR: Asset categories and associated RSF factors

RSF factor Components of RSF category

0% • Coins and banknotes • All central bank reserves • Unencumbered loans to banks subject to prudential supervision with residual maturities < 6 months

5% • Unencumbered Level 1 assets, excluding coins, banknotes and central bank reserves 15% • Unencumbered Level 2A assets

50%

• Unencumbered Level 2B assets • HQLA encumbered for a period ≥ 6 months and < 1 year • Loans to banks subject to prudential supervision with residual maturities ≥ 6 months and < 1year • Deposits held at other financial institutions for operational purposes • All other assets not included in the above categories with residual maturity < 1 year.

65% • Unencumbered residential mortgages with a residual maturity ≥1 year and risk weight ≤ 35%

• Other unencumbered loans (except to financial institutions) with residual maturity ≥1 year and risk weight ≤ 35%

85% • Other unencumbered loans (except to financial institutions) with risk weights ≥35% and residual maturities ≥ 1 year

• Unencumbered securities that are not in default and do not qualify as HQLA including exchange-traded equities • Physical traded commodities, including gold

100% • All assets that are encumbered for a period ≥ 1 year • Derivatives receivable net of derivatives payable if receivables are greater than payables • All other assets not included in the above categories, including non-performing loans and others.

NSFR: Off-balance sheet categories and associated RSF factors

RSF factor RSF category

5% of the currently undrawn portion

Irrevocable and conditionally revocable credit and liquidity facilities to any client

National supervisors can specify the RSF factors based on their national circumstances

Other contingent funding obligations, including products and instruments such as:

• Unconditionally revocable credit and liquidity facilities;

• Trade finance-related obligations (including guarantees and letters of credit);

• Guarantees and letters of credit unrelated to trade finance obligations; and

• Non-contractual obligations such as

− potential requests for debt repurchases of the bank’s own debt or that of related conduits, securities investment vehicles and other such financing facilities;

− structured products where customers anticipate ready marketability, such as adjustable rate notes and variable rate demand notes (VRDNs); and

− managed funds that are marketed with the objective of maintaining

• Sovereign debt is categorized at the top of the liquidity scale to compute RSF

• Additional incentives to hoard high quality sovereign assets

• Effects on sovereign repos: a matched repos have an ASF-factor of zero, with an RSF-factor of 50 percent.

• Impact on repo costs

NSFR and implications for sovereign debt

Central Counter Parties and trading platforms

• The G20 encouraged the standard setters to create incentives to use Central Counter Parties (CCPs), trading platforms and standardized contracts.

• Shift away from bilateral trading

• The BCBS has materially changed the regime for exposures to CCPs.

• Increase the capital charges associated with bank OTC derivatives and create incentives for banks to use CCPs.

• The use of sovereign debt as collateral in derivative transactions and CCPs could impact pricing, as less supply may be available for trading.

• Those assets will be hoarded by dealers as collateral buffers to support OTC transactions.

Proprietary trading

• Proprietary trading bans for banks may adversely affect liquidity in sovereign bond markets.

• The Volcker Rule in the US prohibits banks from engaging in proprietary trading, or investing in other institutions active in similar activities.

• In the UK and EU, recommendations call for proprietary trading to be conducted in a ring-fenced manner

• Home sovereign debt is typically excluded, but the reorganization of the business impacted bank trading activity in sovereign bond markets.

• Proprietary trading is no longer viewed as a sustainable business model

Conclusions

• The final overall effect from reforms is still unclear

• Existing capital requirements recognize sovereign assets as a free risk or very low risk assets

• Pillar II allows to compensate any deficiency

• LR constraints banks’ sovereign exposures. Disincentive for banks to engage in low-margin and balance sheet intensive activities. Impact on sovereign repo.

• The LCR and the NSFR consider sovereign debt as high quality assets. Incentives for banks to hoard those assets. Less trading and liquidity in secondary markets. NSFR potentially increases the cost of repos

• Increasing use of CCPs and margin and collateral requirements could diminish the availability of government securities.

Thank you

Cristina Pailhé

IFD/CMF Consultant

10th Annual Meeting LAC Debt Group

Asunción, Paraguay

11-13 August 2014