Part V in Our Series on US Bank Capital Requirements

• In our previous blog in this series, we discussed the potential impacts of the Basel III Endgame on large U.S. banks’ capital markets activities.
• To prudently manage and mitigate business risks, commercial end-users (e.g., non-financial corporations, municipalities, and pension funds) often rely directly on the financial products (e.g., derivatives) and services (e.g., securities underwriting) that large banks offer through capital markets activities. The Coalition for Derivatives End-Users recently voiced their concerns about the potential material adverse impacts that could result from the implementation of Basel III Endgame, including higher costs or less availability for certain capital markets products and services.
• In this blog, we take a deeper dive into the potential impacts of the Basel III Endgame on commercial end-users.

Background

The Coalition for Derivatives End-Users recently warned that “specific aspects of the trading book components of the Basel III Endgame reforms could lead to reduced bank participation in certain financial markets, leading to increased risks to financial stability and the broader U.S. economy by concentrating these products in less transparent markets and increasing the costs for end-users.” They also stated that the “new rules will have serious consequences to end-users and far-reaching negative implications for the broader U.S. economy, economic growth, competition and financial stability.”^[1]

Commercial end-users (e.g., non-financial corporations, municipalities, and pension funds) rely directly on the services (e.g., securities underwriting) and products (e.g., financial derivatives) that large banks offer through their capital markets activities.  For example, 75 percent of all equity and debt financing of non-financial corporations is derived through the U.S. capital markets, in contrast to most other countries where traditional bank lending is the major source of funding for businesses.  The capital markets also serve as a key source of financing/refinancing for US municipalities.  Capital markets ensure businesses have easy and consistent access to liquidity and affordable funding to fuel growth and create jobs, and that municipalities have the funds to provide critical civil services respectively.

In addition to securities underwriting, large banks serve as critical counterparties in financial derivatives for commercial end-users, tools they utilize to hedge and mitigate commercial risks associated with their businesses, including interest rate risk, foreign currency risk and commodities risks. The use of financial derivatives to manage commercial risks by commercial end-users benefits the global economy by allowing a range of businesses—including manufacturing, healthcare, agriculture, energy. and technology—to improve their planning and forecasting and offer more stable prices to consumers and more stable contributions to economic growth.

Because of its anticipated significant increase in capital requirements, the Basel III Endgame is expected to materially constrain large banks’ ability to support capital markets.  This could reduce the depth of their products/services offered to commercial end-users, leading to reduced competition, and increasing the cost of raising capital and hedging risk for a wide variety of commercial end-users.

The Basel III Endgame’s Potential Impacts on Commercial End-Users

The Basel III Endgame reforms consist of four components: the credit risk framework, the market risk framework, the CVA risk framework, and the operational risk framework.  All four components are expected to have meaningful impacts on banks’ capital markets activities.  Given the intended scope, this blog highlights only a few provisions (namely, the treatment of unrated counterparties, the impacts of the revised CVA risk framework, and the treatment of the service component under the revised operational risk framework) of the Basel III Endgame to demonstrate its potential impacts on commercial end-users regarding securities insurance and the use of derivatives to manage business risks.^[2]

1) Securities Underwriting

The Basel Endgame reforms will make securities underwriting activity significantly less economically viable for large banks, both because the treatment of such activity under the new Fundamental Review of the Trading Book (“FRTB”) and because of the treatment of such fee-based services under the revised standardized approach to operational risk.

Currently, the largest banks play a critical role in underwriting securities including mortgage-backed securities (“MBS”), corporate bonds, equities, ABS, and munis.  This is shown in the table below which presents the market shares statistics across three types of firms underwriting various securities, i.e., the Global Systemically Important Banks (or “GSIBs”) – firms expected to bear the lion’s share of the Basel III Endgame capital increases, non-GSIB CCAR firms (or “CCAR ex GSIB”), and other firms (or “Other”, ~200 firms):

In the last two decades, US GSIBs market share in nearly all types of securities underwriting have steadily and materially decreased.  Foreign GSIBs and US regional banks grew their market shares somewhat in certain markets during the same period, while other underwriters have seen their underwriting role expand rapidly.  The charts in Appendix 1 depict the historical trend of market shares of securities underwriting by the three different types of market players.

The Basel III Endgame explicitly requires banks to include certain securities (i.e., securities that are expected to be actually purchased by the bank) arising from underwriting activities in the trading book and therefore subjects them to the FRTB’s capital treatment.^[3] No such requirements exist under the current capital rules and as a result, certain underwriting activities will be hit particularly hard by the FRTB.  The Basel Committee expects the FRTB to increase market risk capital requirements by 57% for GSIBs globally, a figure that may understate the impacts for the largest U.S. institutions given their greater capital markets focus.  These changes are expected to materially compress profitability and, thereby, the viability of certain products and services offered by banks, including securities underwriting.

In addition, securities underwriting service is a fee-based business (as is the case for custody services and wealth management services).  Fee incomes and expenses feed into the “services component” of the revised operational risk framework.^[4]  In short, the new standardized operational risk framework capitalizes services, such as securities underwriting, in the same way as high yield debt and even equity exposures.  However, the comparison is not a fair one for two reasons.  First, the high yield debt and equity exposures are on banks’ balance sheet, and their values are volatile.  Therefore, they are expected to attract higher risk weights.  Second, service incomes generated from securities underwriting, custody and wealth management services are generally steady and tend not to give rise material losses.  Moreover, the operational risk framework and credit risk frameworks are designed to capitalize very different risks.

As a result, the revised operational risk framework may over-conservatively capitalize banks’ capital markets services activities, including securities underwriting, custody, and wealth management services.  This would disincentivize banks from providing these capital markets services^[5] and disrupt banks’ efforts in “developing sustainable revenue streams beyond net interest income … [remain] vital in order to buttress [banks’] profitability” which clearly “matters for financial stability.”^[6]

2) Derivatives

Commercial end-users employ derivatives primarily to manage and mitigate risks associated with operating their businesses.  To help facilitate the efficient access to the derivatives hedging market, Congress exempted end-users that are hedging business risks from having to post margin on uncleared derivatives transactions and from having to clear derivatives transactions.^[7]  However, the Basel Endgame reforms could effectively undermine this exemption, making it more expensive and difficult for end-users to hedge their non-financial business risks.

In order to be consistent with the congressional statute, the Standardized Approach for Counterparty Credit Risk (“SA-CCR”) rule^[8] jointly finalized by the three federal banking agencies (i.e., the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation) in 2020,^[9] sets out a lower exposure multiplier when a bank’s derivatives counterparty is a commercial end-user (i.e., a multiplier of 1 for commercial end-users as the bank’s counterparties instead of 1.4 for other counterparties), thus mitigating some of the impacts of higher capital requirements resulting from the SA-CCR.^[10]  However, the significant increase in Credit Valuation Adjustment (or “CVA”) capital requirement as part of the Basel III Endgame would effectively undo the modest benefits afforded to end-users by the lower multiplier under the final SA-CCR rule.^[11]

To illustrate the impacts of the revised CVA risk framework, consider the following stylized example.  A pension fund (or “Pension Fund”) hedges its interest rate risk using a 3-year interest rate swap contracted with a bank (or “Bank”).  For simplicity, assume the Exposure-at-Default (or “EAD”) of the interest rate swap contract calculated using the SA-CCR equals to $10mn.  The Pension Fund has no listed securities and is unrated.  And the 1-year probability of default of the Pension Fund is estimated to be 0.1% ̶  equivalent to a S&P rating between A and BBB, i.e., investment grade rating.^[12]  The Bank is subject to CVA risk capital requirement.

In the US, the Dodd-Frank Act prohibits the use of external credit rating in bank capital rules.  The US bank capital rules define investment grade as:^[13]

“Investment grade means that the entity to which the Board-regulated institution is exposed through a loan or security, or the reference entity with respect to a credit derivative, has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity or reference entity has adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is expected.”

For unrated corporate exposures, the Basel 3 Endgame provides that:^[14]

“Banks in jurisdictions that do not allow the use of external ratings for regulatory purposes may assign a 65% risk weight to exposures to “investment grade” corporates … When making this determination … the corporate entity (or its parent company) must have securities outstanding on a recognized securities exchange.”

The example considers investment grade determination for counterparties with and without the “securities listing” criterium sets out in the Basel III Endgame.  The table below presents the resulting CVA capital increase due to the revised CVA risk framework.  Implementing the securities listing requirement in investment grade determination the Basel III Endgame raises CVA capital requirement on the interest rate swap transaction 4.13x relative to the current capital rules.  Eliminating the listing requirement significantly reduces the resulting CVA capital, though it would still be at 1.73x that of the current capital rules.  The results indicate that securities listing should not be required in investment grade determination under the Basel III Endgame implementation:

Conclusion

Commercial end-users rely directly on the capital markets services (e.g., securities underwriting) and products (e.g., financial derivatives) that large banks provide through their capital markets activities.  The potential significant increase in capital requirements for large banks’ capital market activities due to the Basel III Endgame could materially reduce the depth of banks’ products and services offerings to end-users, which in turn leads to reduced competition and increased cost of raising capital and hedging risk for a wide variety of commercial end-users.   As a result, some end-users could encounter difficulties in their access to liquidity and affordable funding to fuel growth and create jobs and provide critical civil services (in the case of municipalities).   The treatment of unrated corporate exposures under the revised credit risk framework and the services component under the new operational risk framework are among the factors leading to the significant capital increase.  The straightforward changes we propose in this blog would help mitigate those impacts and should be adopted by the banking agencies as they implement the Basel III Endgame reforms.

Dr. Guowei Zhang is Managing Director and Head of Capital Policy for SIFMA

Ms. Katie Kolchin, CFA is Managing Director and Head of Research for SIFMA

Dr. Peter Ryan is Managing Director and Head of International Capital Markets and Strategic Initiatives for SIFMA

Mr. Carter McDowell is Managing Director and Associate General Counsel for SIFMA

Appendix 1: Securities Underwriting

• GSIBs

 

• CCAR ex-GSIBs

 

• Other

^[1] https://subscriber.politicopro.com/f/?id=00000189-28e1-d8b7-a9bb-eeefcfde0000

^[2] The impacts of the revised market risk framework, or the Fundamental Review of the Trading Book, have been discussed in Part II and Part III of this blog series.

^[3] See the Basel RBC 25.6: “instruments resulting from underwriting commitments, where underwriting commitments refer only to securities underwriting, and relate only to securities that are expected to be actually purchased by the bank on the settlement date.”

^[4] See the Basel OPE 25. The revised standardized approach for operational risk capital requirements largely relies on a financial-statement-based proxy known as the Business Indicator (or “BI”).  The BI is based on certain balance sheet items and is calculated as the sum of three components: an interest, leases, and dividend component; a services component; and a financial component.  Each component is calculated based on the income generated by the relevant activities.  The BI is then multiplied by corresponding coefficients (i.e., 12%, 15%, and 18%, or “Coefficient”) to generate the Business Indicator Component (or “BIC”, BIC = BI x Coefficient).  The BIC is in turn multiplied by an Internal Loss Multiplier (or “ILM”), which depends on each bank’s historical losses over the prior ten years.[4]  A bank’s risk weighted asset (or “RWA”) for operational risk is then calculated as the BI x Coefficient x ILM x 12.5.  Thus, if assuming ILM equals to 1 and viewing BI as operational risk “exposure”, Coefficient x 12.5 essentially serves the role of the operational risk RWA risk weights. Focusing on the services component, since the coefficients vary from 12%, 15%, up to 18% depending on size the BI, the corresponding equivalent RWA risk weights are 150%, 187.5%, and 225%.  In comparison, the Basel III Endgame assigns RWA risk weight of 150% to corporate exposures rated below BB- (or “high yield”), and risk weight of 250% to public equity holdings (See the Basel CRE 20).

^[5] One way to mitigate the over-conservativeness may be to multiply the services component by a scaler which essentially scales the operational risk RWA risk weight for services component down to an appropriate level.  For example, a scaler of 1/1.875 would translate into an average operational risk RWA risk weight of 100% instead of 187.5%.  Under the Basel III Endgame (Basel CRE 20), 100% risk weight for corporate exposure corresponds to an external credit rating of BB+ to BB-.

^[6] See ECB Vice-President Luis de Guindos remark on “Challenges for bank profitability”, May 1, 2019.

^[7] See the Business Risk Mitigation Price Stabilization Act of 2015. “Forcing businesses to post margin not only ties up capital, but also makes it more expensive for firms to utilize the risk management tools that they need to protect their businesses from uncertainty. Today’s bill clarifies in statute that Congress meant what it said when it exempted end users from margin and clearing requirements. Specifically, it ensures that those businesses which are exempt from clearing their hedges are also exempt from margining those hedges.” 114th Congr. Rec. H-67-68 (Jan. 7, 2015) (state of Rep. Mike Conaway).

^[8] See in 12 CFR Part 217 Subpart E §217.132.

^[9] See https://www.federalregister.gov/documents/2020/01/24/2019-27249/standardized-approach-for-calculating-the-exposure-amount-of-derivative-contracts

^[10] Switching to SA-CCR from the Current Exposure Method (or “CEM”) and accounting for the benefits of the adjustment for commercial end-users, the new SA-CCR-based capital requirements increased by 4.2x.  Without recognizing the supervisory adjustment, the increase in capital requirement would have been 5.88x.

^[11] See the Basel III Monitoring Report Feb. 2023.

^[12] See https://www.fixedincomenews.com.au/sp-default-rate-study/

^[13] See in 12 CFR Part 217 Subpart A §217.2.

^[14] See the Basel CRE 20.

^[15] The current CVA risk capital requirements are calculated according to the simple CVA approach sets out in 12 CFR Part 217 Subpart E §217.132.

^[16] The revised CVA risk capital requirements are calculated using the BA-CVA approach as prescribed in the Basel 3 Endgame MAR50 (applying the counterparty risk weight of 12% for unrated financials).

^[17] Apply risk weight for investment grade financials (i.e., 5%) instead of 12% for unrated financials.

Related Resources

• Virtual Discussion

  SIFMA Basel III Endgame Roundtable

  Wednesday, July 12 10:00 a.m. - 1:00 p.m.

• Pennsylvania + Wall Blog

  Blog Series on US Bank Capital Requirements