Federal Reserve Meeting on LCR and Margin for Non -Cleared Swaps
Key Topics & Takeaways
- The Fed unanimously approves a Final Rule on the Liquidity Coverage Ratio and a Proposed Rule on Margin Requirements for Non-Cleared Swaps.
- Tarullo said the Fed anticipates a future rulemaking to extend the LCR to U.S. intermediate holding companies and branches of large foreign banking organizations.
- Fed staff said they will begin work to develop criteria for determining if a municipal bond can meet the requirements to be considered a “high quality liquid asset” (HQLA).
- Fed staff said bank participation in the municipal market is “relatively limited” at around 10 to 15 percent.
- Fed staff stressed that there will still be an important role for the Fed as the lender of last resort.
- Re-proposal of rule incorporates “significant changes” that have been made due to public comments on the first proposal in 2011 and reflects international standards completed in 2013.
- Proposal “would not impose specific numerical, initial, or variation margin requirements on swaps” with non-financial end-users.
- A swap entity would be required to place initial margin at a third-party custodian and the custodian agreement “must prohibit the custodian from re-hypothecating the collateral held by the custodian.”
- Certain foreign swap entities would be permitted to comply with home rules on their swaps with U.S. counter-parties if the agencies determine that the foreign rule is comparable.
Meeting Participants
- Janet Yellen, Chairman
- Stanley Fischer, Vice Chairman
- Daniel Tarullo, Governor
- Jerome Powell, Governor
- Lael Brainard, Governor
- Michael Gibson, Director of Banking Supervision and Regulation
- David Emmel, Manager of Credit, Market, and Liquidity Policy
- Bill Nelson, Deputy Director of the Division of Monetary Affairs
- Mark Van Der Weide, Deputy Director of Policy of Banking Supervision and Regulation
- Sean Campbell, Deputy Associate Director of the Division of Research and Statistics
- Anne Harrington, Senior Attorney in the Legal Division
Opening Statements
Chair Yellen
Chair Janet Yellen, in her opening remarks, stated that the final rule to implement the liquidity coverage ratio (LCR) “will complement the Federal Reserve’s enhanced supervision and regulation” of large financial institutions and their liquidity positions, and “thus further bolster financial stability.” She then noted that the proposed rule on margin requirements for non-cleared swaps reflects comments received on the Fed’s first proposal on this topic in 2011 and includes changes made in light of international standards developed in 2013.
Governor Tarullo
Governor Daniel Tarullo, in his statement, said that adoption of the LCR “will establish, for the first time, a liquidity rule applicable to the entire balance sheet of large banking organizations” and that it was created as “a response to the fact that liquidity squeezes were the agents of contagion in the financial crisis.”
Tarullo explained that the LCR will provide a regulatory baseline for supervisors conducting “horizontal exams” of liquidity risk management. He added the Net Stable Funding Ratio (NSFR), “when work is completed” will be a third element of liquidity regulation “to further limit destabilizing funding runs and credit contraction, while not creating incentives for firms to hoard liquidity in periods of stress.”
Tarullo noted that the LCR applies differently to bank holding companies of “differing systemic importance” and outlined that the rule: 1) does not apply to banks with less than $50 billion in assets; 2) is less stringent on banks between $50-$250 billion; and 3) applies fully to banks with $250 billion or more in assets and or banks with “substantial international operations.”
The rule will only apply to domestic bank holding companies, he added, but said the Fed anticipates a future rulemaking to extend the LCR to U.S. intermediate holding companies and branches of large foreign banking organizations. He also mentioned that the rule will not apply to non-bank systemically important financial institutions (SIFIs), as designated by the Financial Stability Oversight Council (FSOC), as their liquidity standards will be based on individual determinations.
Next, Tarullo stated that there is still work to be done to address risks associated with short-term wholesale funding beyond the 30-day window and for matched repurchase (repo) books, saying that the NSFR and capital surcharges will seek to address some of these concerns. He also noted that the Fed is working with international counterparts on proposals for minimum collateral haircuts for securities financing transactions.
Lastly, Tarullo explained that while state and municipal bonds are currently excluded from the list of assets that qualify as high quality liquid assets (HQLA), “public comments and staff analysis over the past several months suggest that the liquidity of some state and municipal bonds is comparable to that of the very liquid corporate bonds that can qualify” and said the Fed staff is working to develop criteria for determining if a municipal bond meets the HQLA requirements.
Michael Gibson, Director of Banking Supervision and Regulation, said that the LCR will become part of the Fed’s “comprehensive liquidity risk oversight program” and will allow for tailored as well as common assessments of a firm’s liquidity risk “that allows comparisons across the industry.”
David Emmel, Manager of Credit, Market, and Liquidity Policy, noted that during the financial crisis, many governments and central banks provided “unprecedented liquidity support” as institutions withdrew lending from other market participants to meet their own liquidity needs.
Emmel explained that the final rule establishes a “standardized liquidity stress scenario” with fixed projected inflows and outflows of cash. The standardized stress scenario requires a covered company to maintain an amount of high-quality liquid assets, or HQLA, to cover its total net cash outflows over a perspective 30-day period, he added.
The most notable concerns raised in the comment period on the initial proposal, he explained, were related to: 1) the transition period for implementation; 2) operational challenges of computing the LCR on a daily basis; 3) the mechanics for capturing a firm’s maturity mismatch within a 30-calendar-day stress period; 4) the treatment of municipal deposits and municipal securities; and 5) operational challenges of using a 21-day stress period for firms subject to the modified LCR.
Emmel explained that Basel standard global banks are required to have a LCR greater than 60 percent by January 1, 2015, but U.S. firms would have been required to have a LCR greater than 80 percent starting January 1, 2015. He said the Fed staff believes the transition periods are appropriate for large U.S. institutions because they have greatly improved their liquidity positions but said that for smaller firms subject to the modified LCR, the rule will not be effective until January 1, 2016.
He noted that implementation of daily calculation requirements will be delayed, with larger firms being phased-in faster than smaller firms. He also said staff modified the final rule so that municipal secured deposits will receive the same or better treatment as unsecured municipal deposits.
On municipal securities being included in HQLA, Emmel said “there are a limited amount of municipal securities that may exhibit characteristics similar to assets that are currently eligible as HQLA” and that “staff recommends further analysis to develop a standard for potentially including some municipal securities as HQLA.” He said staff will develop a new proposal for public comment “to include the most highly liquid municipal securities.”
Emmel also noted that while companies will generally be required to maintain a LCR of 100 percent or greater, there will not be an automatic trigger if a company falls below this level. He explained that the framework will allow for a flexible supervisory response because firms may need to use their HQLA during times of stress.
He concluded that based on the quantitative impact study and supervisory information, “we believe that of the roughly $2.5 trillion system-wide HQLA requirement, the remaining shortfall for firms that are not compliant is $100 billion for all holding companies subject to the full and modified LCR.”
Question and Answer – LCR
Yellen noted that states and municipalities are concerned that the rule will negatively impact their access to the debt market and asked what the likely effects of the rule would be on states and municipalities.
Emmel said “we don’t believe the impact will be very significant” for states and municipalities or that the rule would “be impactful to the municipal market.” He said that bank participation in the municipal market is “relatively limited” at around 10 to 15 percent and that banks typically do not include municipal securities in their liquidity buffer.
Yellen then asked what the economic impact will be on the broader economy and if there is potential for banks to reduce their lending due to these new requirements.
Bill Nelson, Deputy Director of the Division of Monetary Affairs, stated that the regulation, “by design,” will make liquidity transformation more costly as “banks are forced to internalize the external costs that are associated with shortfalls in liquidity” and that this will “make credit a bit more costly.” However, he said that the Fed does not expect an immediate impact as most banks have anticipated this regulation and have come into compliance already.
Nelson stressed that there will still be “a very important role” for the Fed as the lender of last resort.
Tarullo asked how the Fed will be able to communicate when the LCR should be “breached” and when firms should use this liquidity during a period of stress.
Emmel said that part of the Fed’s jobs as supervisors will be to communicate that the LCR is designed to be used in times of crisis and can fall below 100 percent.
Gibson further explained that for capital requirement breaches “there starts to be restrictions on dividends [and] restrictions on compensation” but for the LCR “the only consequence is, you have to have a conversation with your supervisor about how you’re going to deal with the liquidity stress that’s pushed your LCR below 100 percent.” He added that the regulation is “really intended to deal ex ante” and “make sure firms have strong liquidity buffers before a crisis.”
Governor Jerome Powell asked how the LCR addresses different business models, especially for banks between $250 to $700 billion in assets that act more like traditional commercial banks and rely less on short term wholesale funding, but are still subject to the “full strength LCR.”
Emmel replied that the LCR “does adjust to different business models” in that firms who rely less on short term wholesale funding or do not have large off-balance sheet commitments will be subject to smaller LCR requirements. Retail deposits, he explained, have lower outflow rates, compared to short term funding, and thus require less HQLA relative to total assets.
Governor Lael Brainard said that liquidity management has tended to be pro-cyclical and asked how the LCR can be adapted through an economic cycle.
Emmel said that internal models used by firms and the standardized models in the LCR will complement each other and will evolve over time as supervisors learn “different dynamics that exist in different practices.”
Brainard then asked where the LCR falls short when seeking to address risks associated with short-term wholesale funding.
Mark Van Der Weide, Deputy Director of Policy of Banking Supervision and Regulation, replied that the LCR, while good for maturity mismatches in the 30 day window, is “not a sufficient solution to the financial stability risk of short-term wholesale funding.”
He continued that the LCR: 1) misses maturity mismatch inside the 30-day window; 2) does not cover maturity match entirely outside the 30-day window; 3) misses matchbook repo funding; and 4) does not include the shadow banking system.
Van Der Weide said the NSFR “is going to be coming soon” and will address “much maturity mismatch that occurs outside the 30-day window.” He added that the Fed is working on potential capital surcharges for the largest banks and potential minimum margin requirements on securities financing transactions.
Staff Presentation – Margin for Non-Cleared Swaps
Gibson stated that this re-proposal of the rule establishing margin requirements for non-cleared swaps incorporates “significant changes” that have been made due to public comments on the first proposal in 2011 and reflect standards completed in 2013 by the Basel Committee on Banking Supervision (BSBS).
Gibson stated that non-cleared swaps “pose the same type of systemic contagion and spillover risks that materialized in the recent financial crisis” and that margin requirements will reduce these risks by “ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty.” He also said the rule will provide an incentive for central clearing.
Sean Campbell, Deputy Associate Director of the Division of Research and Statistics, explained that the proposed rule “would distinguish among different types of counterparties for purposes of establishing margin requirements” and make a distinction between swaps with other swap entities, swaps with financial end-users, and swaps with non-financial end-users, as the risk levels are different for each of these counterparties.
Initial margin would be required for all non-cleared swaps of a swaps entity, Campbell said, and the specific amount of initial margin collected and posted would depend on the risk of the swap. Swap entities would be allowed to use an approved internal model or a “standardized initial margins schedule,” he added, and said that in both cases, “the initial margin amount would be calibrated to an extreme but plausible loss that would be expected to occur over a 10-day horizon during a period of financial stress.”
He added that swap entities will be allowed to extend “a limited amount of credit to their counter-parties in the form of an initial margin threshold,” thus incentivizing strong counter-party credit risk management.
Variation margin, he continued, will be required to be collected and paid a daily basis for each swap between a swap entity and all of its swap entity and financial end-user counter-parties. He noted that swap entities will not be allowed to extended credit to counterparties for variation margin.
For non-financial end-users, Campbell continued, the proposal “would not impose specific numerical, initial, or variation margin requirements on swaps with these counter-parties.”
Anne Harrington, Senior Attorney in the Legal Division, noted that the proposal establishes the types of collateral that can be used for these margin requirements. She explained that for variation margin, the payment would be limited to cash, while for initial margin, “the range of eligible collateral is significantly broader and would include a variety of high-quality and liquid assets, including certain corporate bonds, sovereign bonds, and equities.” The value of the assets for initial margin, she clarified, would be adjusted “by a risk-based haircut to ensure that the amount of initial margin collected could withstand fluctuations in asset market values.”
Harrington then stated that a swap entity would also be required to place initial margin at a third-party custodian and that “the custodian agreement must prohibit the custodian from re-hypothecating the collateral held by the custodian.”
She also clarified that swaps of foreign swap entities with foreign counter-parties would not be subject to the margin requirements and that “certain foreign swap entities would be permitted to comply with the foreign margin rule on their swaps with U.S. counter- parties if the agencies determine that the foreign rule is comparable to the proposed rule.” This approach, she said, is “intended to limit the extra territorial application of the margin requirements while preserving to the extent possible, competitive equality among U.S. and foreign firms.”
She concluded that the rule would be phased in over time between December 2015 and December 2019.
Question and Answer – Margin for Non-Cleared Swaps
Yellen asked if the proposed rule creates the “appropriate incentives” for swap dealers and swap participants to use central clearing.
Campbell replied there is an economic incentive to clear since the proposal requires margin calibration over a 10 day period of risk, whereas cleared swaps measure only over five days. The result, he said, is that non-cleared swaps will face margin requirements about 40 to 45 percent higher than cleared swaps. He also said a swap dealer has the incentive to centrally clear so that netting benefits of swaps across counterparties can be realized.
Vice Chairman Stanley Fischer asked if there would be any impact on the overall volume of derivatives transactions in the economy as a result of the proposed rule.
Campbell said that measuring the effect on volume of transactions is “not an obvious or simple matter” but that BCBS has estimated that about 60 percent of the market will migrate to central clearing, noting that this percentage will vary by asset class. He stated that the requirements will “be a significant issue that swap end-users are considering as they’re deciding whether and how to use swaps” and that the Fed staff has tried “to ensure that the costs being born upon financial end-users and non-financial end users are not unduly burdensome.”
Fischer asked if the Fed has received any feedback on whether the proposal would be “unduly burdensome.”
Campbell said the Fed has received a significant amount of comments on potential liquidity burdens, but that they tended to be “high level” and without much detail on cost estimates. He said the estimates that the Fed has put together suggest that, in U.S., the total amount of initial margin that might required under the proposal, “might be something on the order of $300 billion.”
Tarullo asked where the rest of the world is in terms of their implementation of margin requirements.
Campbell replied that Europe released its proposal in April, and Japan released its proposal in July. He said that both of these jurisdictions are currently in the process of moving those proposals to the final rule stage. Gibson clarified that these jurisdictions are “slightly ahead of us.”
Powell asked for clarification on the margin requirements for commercial end-users and if it is okay if no margin at all is collected.
Campbell said that this is correct; that margin for non-financial end-users is not required if the swap entity determines that no margin is needed to address counterparty risk. He clarified, “to the extent that there is a requirement, the requirement is that the swap dealer engage in a credit assessment and act accordingly.”
Powell noted that the rule defines “material swaps exposure” at $3 billion. He asked what the effect of this level is and why other jurisdictions, such as Japan and Europe have set this level substantially higher.
Campbell said that setting the exposure level at this value reduces the total amount of initial margin requirement “but probably has a somewhat lesser effect than the initial margin threshold of $65 million.” He added that the higher level seen in other jurisdictions “seemed not to be compatible with the underlying notion for the de minimis level, which is essentially, to carve out folks that would be nowhere near the initial margin threshold of $65 million.” He said the Fed is hopeful that as other jurisdictions finalize their rules, there will ultimately be a final determination on where the right level is.
For more information on the meeting and to view an archived webcast, please click here.
Additional materials:
- Board Memo – Liquidity Coverage Ratio (PDF)
- Board Memo – Margin and Capital Requirements for Covered Swap Entities (PDF)
- Federal Register Notice – Liquidity Coverage Ratio (PDF)
- Federal Register Notice – Margin and Capital Requirements for Covered Swap Entities (PDF)
Press Releases:
Key Topics & Takeaways
- The Fed unanimously approves a Final Rule on the Liquidity Coverage Ratio and a Proposed Rule on Margin Requirements for Non-Cleared Swaps.
- Tarullo said the Fed anticipates a future rulemaking to extend the LCR to U.S. intermediate holding companies and branches of large foreign banking organizations.
- Fed staff said they will begin work to develop criteria for determining if a municipal bond can meet the requirements to be considered a “high quality liquid asset” (HQLA).
- Fed staff said bank participation in the municipal market is “relatively limited” at around 10 to 15 percent.
- Fed staff stressed that there will still be an important role for the Fed as the lender of last resort.
- Re-proposal of rule incorporates “significant changes” that have been made due to public comments on the first proposal in 2011 and reflects international standards completed in 2013.
- Proposal “would not impose specific numerical, initial, or variation margin requirements on swaps” with non-financial end-users.
- A swap entity would be required to place initial margin at a third-party custodian and the custodian agreement “must prohibit the custodian from re-hypothecating the collateral held by the custodian.”
- Certain foreign swap entities would be permitted to comply with home rules on their swaps with U.S. counter-parties if the agencies determine that the foreign rule is comparable.
Meeting Participants
- Janet Yellen, Chairman
- Stanley Fischer, Vice Chairman
- Daniel Tarullo, Governor
- Jerome Powell, Governor
- Lael Brainard, Governor
- Michael Gibson, Director of Banking Supervision and Regulation
- David Emmel, Manager of Credit, Market, and Liquidity Policy
- Bill Nelson, Deputy Director of the Division of Monetary Affairs
- Mark Van Der Weide, Deputy Director of Policy of Banking Supervision and Regulation
- Sean Campbell, Deputy Associate Director of the Division of Research and Statistics
- Anne Harrington, Senior Attorney in the Legal Division
Opening Statements
Chair Yellen
Chair Janet Yellen, in her opening remarks, stated that the final rule to implement the liquidity coverage ratio (LCR) “will complement the Federal Reserve’s enhanced supervision and regulation” of large financial institutions and their liquidity positions, and “thus further bolster financial stability.” She then noted that the proposed rule on margin requirements for non-cleared swaps reflects comments received on the Fed’s first proposal on this topic in 2011 and includes changes made in light of international standards developed in 2013.
Governor Tarullo
Governor Daniel Tarullo, in his statement, said that adoption of the LCR “will establish, for the first time, a liquidity rule applicable to the entire balance sheet of large banking organizations” and that it was created as “a response to the fact that liquidity squeezes were the agents of contagion in the financial crisis.”
Tarullo explained that the LCR will provide a regulatory baseline for supervisors conducting “horizontal exams” of liquidity risk management. He added the Net Stable Funding Ratio (NSFR), “when work is completed” will be a third element of liquidity regulation “to further limit destabilizing funding runs and credit contraction, while not creating incentives for firms to hoard liquidity in periods of stress.”
Tarullo noted that the LCR applies differently to bank holding companies of “differing systemic importance” and outlined that the rule: 1) does not apply to banks with less than $50 billion in assets; 2) is less stringent on banks between $50-$250 billion; and 3) applies fully to banks with $250 billion or more in assets and or banks with “substantial international operations.”
The rule will only apply to domestic bank holding companies, he added, but said the Fed anticipates a future rulemaking to extend the LCR to U.S. intermediate holding companies and branches of large foreign banking organizations. He also mentioned that the rule will not apply to non-bank systemically important financial institutions (SIFIs), as designated by the Financial Stability Oversight Council (FSOC), as their liquidity standards will be based on individual determinations.
Next, Tarullo stated that there is still work to be done to address risks associated with short-term wholesale funding beyond the 30-day window and for matched repurchase (repo) books, saying that the NSFR and capital surcharges will seek to address some of these concerns. He also noted that the Fed is working with international counterparts on proposals for minimum collateral haircuts for securities financing transactions.
Lastly, Tarullo explained that while state and municipal bonds are currently excluded from the list of assets that qualify as high quality liquid assets (HQLA), “public comments and staff analysis over the past several months suggest that the liquidity of some state and municipal bonds is comparable to that of the very liquid corporate bonds that can qualify” and said the Fed staff is working to develop criteria for determining if a municipal bond meets the HQLA requirements.
Michael Gibson, Director of Banking Supervision and Regulation, said that the LCR will become part of the Fed’s “comprehensive liquidity risk oversight program” and will allow for tailored as well as common assessments of a firm’s liquidity risk “that allows comparisons across the industry.”
David Emmel, Manager of Credit, Market, and Liquidity Policy, noted that during the financial crisis, many governments and central banks provided “unprecedented liquidity support” as institutions withdrew lending from other market participants to meet their own liquidity needs.
Emmel explained that the final rule establishes a “standardized liquidity stress scenario” with fixed projected inflows and outflows of cash. The standardized stress scenario requires a covered company to maintain an amount of high-quality liquid assets, or HQLA, to cover its total net cash outflows over a perspective 30-day period, he added.
The most notable concerns raised in the comment period on the initial proposal, he explained, were related to: 1) the transition period for implementation; 2) operational challenges of computing the LCR on a daily basis; 3) the mechanics for capturing a firm’s maturity mismatch within a 30-calendar-day stress period; 4) the treatment of municipal deposits and municipal securities; and 5) operational challenges of using a 21-day stress period for firms subject to the modified LCR.
Emmel explained that Basel standard global banks are required to have a LCR greater than 60 percent by January 1, 2015, but U.S. firms would have been required to have a LCR greater than 80 percent starting January 1, 2015. He said the Fed staff believes the transition periods are appropriate for large U.S. institutions because they have greatly improved their liquidity positions but said that for smaller firms subject to the modified LCR, the rule will not be effective until January 1, 2016.
He noted that implementation of daily calculation requirements will be delayed, with larger firms being phased-in faster than smaller firms. He also said staff modified the final rule so that municipal secured deposits will receive the same or better treatment as unsecured municipal deposits.
On municipal securities being included in HQLA, Emmel said “there are a limited amount of municipal securities that may exhibit characteristics similar to assets that are currently eligible as HQLA” and that “staff recommends further analysis to develop a standard for potentially including some municipal securities as HQLA.” He said staff will develop a new proposal for public comment “to include the most highly liquid municipal securities.”
Emmel also noted that while companies will generally be required to maintain a LCR of 100 percent or greater, there will not be an automatic trigger if a company falls below this level. He explained that the framework will allow for a flexible supervisory response because firms may need to use their HQLA during times of stress.
He concluded that based on the quantitative impact study and supervisory information, “we believe that of the roughly $2.5 trillion system-wide HQLA requirement, the remaining shortfall for firms that are not compliant is $100 billion for all holding companies subject to the full and modified LCR.”
Question and Answer – LCR
Yellen noted that states and municipalities are concerned that the rule will negatively impact their access to the debt market and asked what the likely effects of the rule would be on states and municipalities.
Emmel said “we don’t believe the impact will be very significant” for states and municipalities or that the rule would “be impactful to the municipal market.” He said that bank participation in the municipal market is “relatively limited” at around 10 to 15 percent and that banks typically do not include municipal securities in their liquidity buffer.
Yellen then asked what the economic impact will be on the broader economy and if there is potential for banks to reduce their lending due to these new requirements.
Bill Nelson, Deputy Director of the Division of Monetary Affairs, stated that the regulation, “by design,” will make liquidity transformation more costly as “banks are forced to internalize the external costs that are associated with shortfalls in liquidity” and that this will “make credit a bit more costly.” However, he said that the Fed does not expect an immediate impact as most banks have anticipated this regulation and have come into compliance already.
Nelson stressed that there will still be “a very important role” for the Fed as the lender of last resort.
Tarullo asked how the Fed will be able to communicate when the LCR should be “breached” and when firms should use this liquidity during a period of stress.
Emmel said that part of the Fed’s jobs as supervisors will be to communicate that the LCR is designed to be used in times of crisis and can fall below 100 percent.
Gibson further explained that for capital requirement breaches “there starts to be restrictions on dividends [and] restrictions on compensation” but for the LCR “the only consequence is, you have to have a conversation with your supervisor about how you’re going to deal with the liquidity stress that’s pushed your LCR below 100 percent.” He added that the regulation is “really intended to deal ex ante” and “make sure firms have strong liquidity buffers before a crisis.”
Governor Jerome Powell asked how the LCR addresses different business models, especially for banks between $250 to $700 billion in assets that act more like traditional commercial banks and rely less on short term wholesale funding, but are still subject to the “full strength LCR.”
Emmel replied that the LCR “does adjust to different business models” in that firms who rely less on short term wholesale funding or do not have large off-balance sheet commitments will be subject to smaller LCR requirements. Retail deposits, he explained, have lower outflow rates, compared to short term funding, and thus require less HQLA relative to total assets.
Governor Lael Brainard said that liquidity management has tended to be pro-cyclical and asked how the LCR can be adapted through an economic cycle.
Emmel said that internal models used by firms and the standardized models in the LCR will complement each other and will evolve over time as supervisors learn “different dynamics that exist in different practices.”
Brainard then asked where the LCR falls short when seeking to address risks associated with short-term wholesale funding.
Mark Van Der Weide, Deputy Director of Policy of Banking Supervision and Regulation, replied that the LCR, while good for maturity mismatches in the 30 day window, is “not a sufficient solution to the financial stability risk of short-term wholesale funding.”
He continued that the LCR: 1) misses maturity mismatch inside the 30-day window; 2) does not cover maturity match entirely outside the 30-day window; 3) misses matchbook repo funding; and 4) does not include the shadow banking system.
Van Der Weide said the NSFR “is going to be coming soon” and will address “much maturity mismatch that occurs outside the 30-day window.” He added that the Fed is working on potential capital surcharges for the largest banks and potential minimum margin requirements on securities financing transactions.
Staff Presentation – Margin for Non-Cleared Swaps
Gibson stated that this re-proposal of the rule establishing margin requirements for non-cleared swaps incorporates “significant changes” that have been made due to public comments on the first proposal in 2011 and reflect standards completed in 2013 by the Basel Committee on Banking Supervision (BSBS).
Gibson stated that non-cleared swaps “pose the same type of systemic contagion and spillover risks that materialized in the recent financial crisis” and that margin requirements will reduce these risks by “ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty.” He also said the rule will provide an incentive for central clearing.
Sean Campbell, Deputy Associate Director of the Division of Research and Statistics, explained that the proposed rule “would distinguish among different types of counterparties for purposes of establishing margin requirements” and make a distinction between swaps with other swap entities, swaps with financial end-users, and swaps with non-financial end-users, as the risk levels are different for each of these counterparties.
Initial margin would be required for all non-cleared swaps of a swaps entity, Campbell said, and the specific amount of initial margin collected and posted would depend on the risk of the swap. Swap entities would be allowed to use an approved internal model or a “standardized initial margins schedule,” he added, and said that in both cases, “the initial margin amount would be calibrated to an extreme but plausible loss that would be expected to occur over a 10-day horizon during a period of financial stress.”
He added that swap entities will be allowed to extend “a limited amount of credit to their counter-parties in the form of an initial margin threshold,” thus incentivizing strong counter-party credit risk management.
Variation margin, he continued, will be required to be collected and paid a daily basis for each swap between a swap entity and all of its swap entity and financial end-user counter-parties. He noted that swap entities will not be allowed to extended credit to counterparties for variation margin.
For non-financial end-users, Campbell continued, the proposal “would not impose specific numerical, initial, or variation margin requirements on swaps with these counter-parties.”
Anne Harrington, Senior Attorney in the Legal Division, noted that the proposal establishes the types of collateral that can be used for these margin requirements. She explained that for variation margin, the payment would be limited to cash, while for initial margin, “the range of eligible collateral is significantly broader and would include a variety of high-quality and liquid assets, including certain corporate bonds, sovereign bonds, and equities.” The value of the assets for initial margin, she clarified, would be adjusted “by a risk-based haircut to ensure that the amount of initial margin collected could withstand fluctuations in asset market values.”
Harrington then stated that a swap entity would also be required to place initial margin at a third-party custodian and that “the custodian agreement must prohibit the custodian from re-hypothecating the collateral held by the custodian.”
She also clarified that swaps of foreign swap entities with foreign counter-parties would not be subject to the margin requirements and that “certain foreign swap entities would be permitted to comply with the foreign margin rule on their swaps with U.S. counter- parties if the agencies determine that the foreign rule is comparable to the proposed rule.” This approach, she said, is “intended to limit the extra territorial application of the margin requirements while preserving to the extent possible, competitive equality among U.S. and foreign firms.”
She concluded that the rule would be phased in over time between December 2015 and December 2019.
Question and Answer – Margin for Non-Cleared Swaps
Yellen asked if the proposed rule creates the “appropriate incentives” for swap dealers and swap participants to use central clearing.
Campbell replied there is an economic incentive to clear since the proposal requires margin calibration over a 10 day period of risk, whereas cleared swaps measure only over five days. The result, he said, is that non-cleared swaps will face margin requirements about 40 to 45 percent higher than cleared swaps. He also said a swap dealer has the incentive to centrally clear so that netting benefits of swaps across counterparties can be realized.
Vice Chairman Stanley Fischer asked if there would be any impact on the overall volume of derivatives transactions in the economy as a result of the proposed rule.
Campbell said that measuring the effect on volume of transactions is “not an obvious or simple matter” but that BCBS has estimated that about 60 percent of the market will migrate to central clearing, noting that this percentage will vary by asset class. He stated that the requirements will “be a significant issue that swap end-users are considering as they’re deciding whether and how to use swaps” and that the Fed staff has tried “to ensure that the costs being born upon financial end-users and non-financial end users are not unduly burdensome.”
Fischer asked if the Fed has received any feedback on whether the proposal would be “unduly burdensome.”
Campbell said the Fed has received a significant amount of comments on potential liquidity burdens, but that they tended to be “high level” and without much detail on cost estimates. He said the estimates that the Fed has put together suggest that, in U.S., the total amount of initial margin that might required under the proposal, “might be something on the order of $300 billion.”
Tarullo asked where the rest of the world is in terms of their implementation of margin requirements.
Campbell replied that Europe released its proposal in April, and Japan released its proposal in July. He said that both of these jurisdictions are currently in the process of moving those proposals to the final rule stage. Gibson clarified that these jurisdictions are “slightly ahead of us.”
Powell asked for clarification on the margin requirements for commercial end-users and if it is okay if no margin at all is collected.
Campbell said that this is correct; that margin for non-financial end-users is not required if the swap entity determines that no margin is needed to address counterparty risk. He clarified, “to the extent that there is a requirement, the requirement is that the swap dealer engage in a credit assessment and act accordingly.”
Powell noted that the rule defines “material swaps exposure” at $3 billion. He asked what the effect of this level is and why other jurisdictions, such as Japan and Europe have set this level substantially higher.
Campbell said that setting the exposure level at this value reduces the total amount of initial margin requirement “but probably has a somewhat lesser effect than the initial margin threshold of $65 million.” He added that the higher level seen in other jurisdictions “seemed not to be compatible with the underlying notion for the de minimis level, which is essentially, to carve out folks that would be nowhere near the initial margin threshold of $65 million.” He said the Fed is hopeful that as other jurisdictions finalize their rules, there will ultimately be a final determination on where the right level is.
For more information on the meeting and to view an archived webcast, please click here.
Additional materials:
- Board Memo – Liquidity Coverage Ratio (PDF)
- Board Memo – Margin and Capital Requirements for Covered Swap Entities (PDF)
- Federal Register Notice – Liquidity Coverage Ratio (PDF)
- Federal Register Notice – Margin and Capital Requirements for Covered Swap Entities (PDF)
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