By disregarding previous analysis of the impact capital reforms can have on the derivatives market, the authors argue federal banking regulators will harm businesses’ ability to hedge risk.
By David Murphy and Sayee Srinivasan
What are hedging markets?
Derivatives markets allow hedgers to shift unwanted risks from themselves to other market participants who are willing to take them on. For example, farmers producing corn might guarantee the price at which they can sell their product once it has been harvested by selling corn futures. By doing this, they can concentrate on farming without having to worry about whether corn prices are rising or falling while their crop is growing. On the other side of this trade might be a cereal producer who wants to lock in the price at which they buy corn in the future. Hedging is important because it allows individuals and businesses to operate more efficiently by reducing uncertainty. Simply put, it supports the economy and allows it to grow more quickly.
Banks provide access to hedging markets in three ways. For exchange-traded markets, such as those for futures, they or their affiliates act as clearing members, allowing their clients to buy and sell hedging and investment products on the exchange. For some cleared over-the-counter markets, such as the interest rate swap market used to hedge interest rate risk, they perform a similar function in facilitating and submitting trades to a clearing house. Finally, banks trade more bespoke derivatives directly with their clients, often hedging themselves on an exchange.
This market access business is typically very low-risk. Clients must settle their profits and losses at least daily. In addition, they must post additional collateral, which is sized to cover nearly all possible losses on their positions. A market access provider will only suffer a loss if the client defaults and their positions lose more than the value of the collateral posted before being closed out.
The second category of transactions — client cleared OTC derivatives — is particularly important because regulators imposed a set of rules after 2008 that require all financial institutions and many nonbanks to clear standardized OTC derivatives transactions. This “clearing mandate” means that clearing houses now play a key role in hedging markets. Cleared over-the-counter derivatives are highly liquid, and both financial institutions and their clients require access to them if they want to hedge efficiently.
Why do these markets matter?
Risk transfer markets have their roots in agriculture, where farmers use exchange-traded futures to protect the price of their harvest. Food and commodity producers and consumers also rely on these markets for price signals to determine what crops to grow. These markets bring together a wide range of participants whose collective activity facilitates efficient price discovery as well as a cost-effective means of hedging risk for farmers. Absent access to these markets, both producers and consumers will be exposed to more boom-and-bust volatility, and the average U.S. household will pay more for its daily groceries, fuel and goods.
What is the role of bank capital requirements in shaping banks’ businesses?
Regulatory capital requirements are binding constraints on many large banks. These constraints include minimum common equity tier 1 capital requirements, an additional stress capital buffer determined from stress tests carried out by supervisors, and a further surcharge if the bank has been defined as a global systemically important bank. Banks actively manage their businesses to meet the multiple constraints imposed by capital regulation. This management typically involves calculating the total contribution of each business line to the bank’s various capital requirements and comparing that contribution to the business lines’ profitability. Areas that do not provide a sufficient return on capital are often restructured or eliminated. This means that if the capital required to support a business line rises significantly, the bank will charge more or less of that business will be conducted. The bank may even stop providing the affected set of services completely.
Several parts of the endgame proposals will, if finalized, substantially increase capital requirements for providing market access. The agencies propose to revise how capital add-ons for the eight largest U.S. banks — the GSIB surcharges — are calculated. The changes will allocate a higher charge for the provision of client clearing services. The capital required for the risk that client credit quality will decrease, or “CVA risk,” as it is known, will also increase. Finally, regulators propose the widespread adoption of an indicator of counterparty credit risk — the standardized approach to counterparty credit risk, or SA-CCR — which overstates risk compared to the already-prudent methods used by clearing houses. Box 1 sets out some more details of these proposals.
The effect of the endgame proposals on the economy
When mandatory central clearing requirements were implemented, it would have been reasonable to expect that there would be an increase in the number of firms offering client clearing services. Unfortunately, we have seen a steady drop in the number of clearing firms; worse, there has been a concentration of clearing activity among the largest firms. This is especially the case in the U.S. as all six of the largest six providers of client clearing are large U.S. banks. The market for these services is already concentrated. The proposals will make this worse.
It is highly likely that banks will react to these proposals, if finalized, by increasing fees for providing market access, reducing the amount of risk that they allow clients to transfer, and refusing to provide access at all to the least profitable clients. As a result, the proposed rules will have a profound impact on the ability of businesses to hedge their risks. At the margin, less hedging will occur, exposing companies to more risk. In what one can only hope is an unintended consequence, smaller banks looking to hedge their interest rate risks will find it increasingly difficult to access these markets. The failure of Silicon Valley Bank demonstrates that the consequences of this can be dire. As end users exit from the markets, the quality of price discovery will deteriorate, which in turn will negatively impact the broader market as many commercial contracts are priced with reference to derivatives market prices.
These effects have already been predicted by authorities
Regulatory bodies have already analyzed the impact of capital reforms on risk transfer markets. In 2017, the Financial Stability Board commissioned an international team, including representatives from the Federal Reserve, to analyze the impact of the post-2008 reforms on derivatives markets. (We were the co-chairs of this Derivatives Assessment Team.) The DAT report highlighted concentration in client clearing service provision and concerns that capital reforms were not supporting the authorities’ goal of facilitating centrally cleared derivatives markets. It provided evidence that, as capital requirements become binding, banks will ration the provisions of services, including risk transfer and credit, to their clients. Further, end users “are often more likely to hold directional positions than dealers, so the level of market risk associated with client cleared positions can often be higher than implied by relative notional levels.” The capital required to support these trades will be higher than clients who trade actively. As regulatory capital requirements increase, the cost of servicing end user clients will increase, disincentivizing banks from providing derivatives markets access to them.
The DAT report also highlighted that, while many large clients with active trading operations access markets through multiple clearing firms, the average client — which will be the typical smaller hedger — has just one clearing member. The proposal will serve as a binding constraint for all banks offering clearing services. If any of these banks decides to offboard an existing client, the client will likely have a tougher time finding another bank to accept it as a client. Worse, if a bank decides to exit the client clearing business, none of the other banks will be able to accept all of its clients.
The DAT report recommended a revision to bank capital rules in order to ensure that banks were not disincentivized from providing clearing services. This revision was subsequently enacted in the Basel standards — an area where U.S. regulators are diverging from the Basel standards to the detriment of U.S. banks and markets — reflecting international bank supervisors’ understanding of the importance of access to cleared derivatives markets. The U.S. proposal will upset this effective, carefully designed framework, which allows banks to support the economy while being prudently capitalized.
The endgame proposals have not been justified
The authorities’ failure to justify their proposals does not just extend to ignoring the DAT report. They have provided no analysis to support the need for higher minimum capital for derivatives intermediation. Indeed, as we noted above, what research there has been points to the importance of incentivizing the provision of risk transfer services. The authorities’ lack of justification is concerning because, under the Administrative Procedure Act, agencies “must explain the assumptions and methodology” underlying a proposed rule “and, if the methodology is challenged, must provide a complete analytic defense.
It is also disquieting that what overall rationale the agencies have provided for their proposed rules is, at best, disingenuous. Federal Vice Chair of Supervision Michael Barr recently justified higher capital requirements by saying that, when a bank suffers a loss, “capital is able to help absorb the resulting loss and, if sufficient, allow the bank to keep serving its critical role in the economy.” This is true, but it does not justify higher minimum capital requirements. A capital requirement must be met at all times: failure to do so results in supervisory intervention and will certainly cause a loss of confidence in the bank. Thus, the bank capital required to support minimum capital requirements is not loss absorbing on a going-concern basis.
Belatedly, the authorities have announced a Quantitative Impact Study on the effect of the endgame proposals. However, this study will simply examine the additional capital burdens the proposals will impose. It will not examine whether these burdens are justified, given the risks being run, or how banks will react. Nor will it study how banks will restructure their businesses in response, or the effect of that on their customers and, consequently, the real economy.
An alternative path
Barr himself, in a 2006 paper he wrote with New York University’s Geoffrey Miller, suggests the answer to these issues. He comments on the openness of the international bank capital rulemaking process to comments and suggests that its legitimacy was supported by its responsiveness “to suggestions made during the notice and comment process.” This is an instance where the agencies should be similarly responsive. They should commission a more comprehensive study that examines not just the capital impact of their proposals but the costs and benefits of it for the whole economy, including its effects on derivatives, hedging and their use for risk management by businesses and banks. The DAT report demonstrates that it is possible to examine not just regulatory requirements, but also their impact, on the cost and structure of risk transfer.
The need for higher minimum capital requirements and higher GSIB surcharges remains unproven. Before imposing any increase, the agencies should demonstrate that they are justified. Then, if they are, the charges should be allocated so as to create the least damage to the economy. The likely result of this would be a withdrawal of the proposed changes to the GSIB surcharges, elimination of the CVA risk charges on client-cleared positions and a recalibration of the SA-CCR.
David Murphy is a visiting professor in practice in the Law School at the London School of Economics and Political Science. Sayee Srinivasan is chief economist at ABA.