Kathleen A. Scott

Non-financial commercial companies (commercial end-users) often secure their derivatives transactions, such as swaps, with financial institutions in a manner other than posting cash margin, such as by granting liens on the commercial end-user’s assets. However, a pending proposal to revise U.S. bank risk-based capital rules regarding derivatives may have the indirect consequence of possibly lessening the ability of commercial end-users to enter into such transactions with U.S. banking organizations (banks).

This month’s column will discuss this proposal and the concerns commercial end-users have raised about the proposal in its current form.

Background

As has been discussed before in this column, banks are required to calculate their capital using a risk-based approach—that is, the riskier the asset, the more capital that must be reserved against it. Large banks can use their own internal models approved by their respective regulators (the Advanced Approaches method), others use a standardized approach (the Standardized Approach method), which assigns risk weights to categories of assets. The Advanced Approaches banks must use the Standardized Approach method of calculation as a floor for their internal model calculations.

The proposed regulations, jointly issued by the Federal Reserve Board, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (collectively, the Agencies), would revise banks’ risk-based capital requirements for measuring counterparty credit risk posed by derivatives contracts.

With respect to derivatives transactions, banks must hold regulatory capital based on the exposure amount of its derivatives contracts in order to address the credit risk that a counterparty to a derivatives transaction with the bank will default on its payment obligation. Up to now, the Advanced Approaches banks that have approved internal models can use them to calculate the exposure amounts, and other banks using the Standardized Approach use the current exposure methodology (CEM), which generally is calculated as the sum of its current credit exposure and potential future exposure.

The Agencies’ Proposal

The Agencies’ proposal would establish the “Standardized Approach for Measuring Counterparty Credit Risk” (SA-CCR) as an alternative approach to the CEM. The proposed SA-CCR is a more complex calculation. In the Agencies’ view, SA-CCR better reflects the current derivatives market and would provide important improvements to risk sensitivity, resulting in more appropriate capital requirements for derivatives contracts exposure.

A bank required to use the Advanced Approaches to calculating its risk-based capital (generally, one that has $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure, or is a subsidiary of an Advanced Approaches bank) would be required to use SA-CCR for purposes of calculating both their standardized basic total risk-weighted assets that is the floor for their internal model calculations, and for certain other capital requirements. Standardized Approaches banks would be allowed to use either CEM or SA-CCR to determine the exposure amount for their derivative contracts.

The proposed revision was prompted by a change in international risk-based capital standards issued by the Basel Committee of the Bank for International Settlements, a group of international bank regulators. The Basel Committee’s purpose in formulating this standard was part of its strengthening of capital requirements after the financial crisis from 2008. Basel standards are adopted individually by each jurisdiction, which leads us to the Agencies’ proposal. The Agencies note in the commentary accompanying the proposed rule that the proposed rule is “substantially” in compliance with the international standard.

The commentary provides an extensive discussion of how the SA-CCR would work. If the proposal is adopted in its present form, banks will need to reserve more capital to engage in transactions where margin is not posted. As a result, banks may either pass on the additional capital costs to their counterparties, including their commercial end-users, or perhaps even exit that market altogether, thus shrinking the pool of available lenders willing to still enter into unmargined transactions secured by other assets. The Agencies address this point, noting in the commentary that for these “unmargined” transactions, the capital costs indeed could go up.

Under the Agencies’ views, the current CEM is not as risk-sensitive as the proposed SA-CCR. It is important to note that CEM also predates the 2015 regulations that require cash or fairly liquid margin to be posted for swaps not cleared through a central counterparty (“uncleared swaps). However, the mandatory margin regulations are not applicable to, among other entities, a commercial end-user using the swap to hedge or mitigate its commercial risk.

In the commentary, the Agencies discuss margined contracts generally as a risk-reducer and do not discuss the potential outcome of adoption of the SA-CCR for unmargined contracts, except to note that in analyzing the impact of the proposed rule, and reviewing data and the change in exposure amount between CEM and SA-CCR, the “exposure amount of margined derivative contracts for these firms would decrease by approximately 44 percent, while the exposure amount of unmargined derivative contracts for these firms would increase by approximately 90 percent” (emphasis added). As noted above, the “exposure amount” is the basis for the capital calculation.

Whether a bank must or may switch to the SA-CCR approach, the proposal is not clear on whether banks will be required to conform all their existing contracts using CEM to SA-CCR, or whether these contracts will be grandfathered until their termination or extension.

Commercial end-users have been submitting comments to the Agencies, voicing their concerns about a possible adverse impact if the rule is finalized as proposed. Comments have been submitted by several industry groups, primarily from the energy industry, but comments also have been submitted by representatives from the alcohol and beef industries. While the direct impact of SA-CCR is on the banks, the commercial end-users are noting the possible collateral consequences of the rule for them.

Many commenters raised the same points, regardless of industry, including the following:

The current system works quite well. Derivatives are utilized by businesses of all sizes to manage their business risks, which are not the same as for financial companies. Margining is not considered market practice for commercial end-user derivatives transactions, whereas security interests and letters of credit are industry-accepted credit mitigation tools. Moreover, collateral-based derivatives transactions usually are over-collateralized in relation to their exposure under the contract.

The commercial end-user derivatives market is small. One commenter estimated that the commercial end-user derivatives market constituted only 5 percent of outstanding derivatives by gross market value and 2 percent of outstanding derivatives by notional value, citing statistics compiled by the Bank for International Settlements.

Commercial end-users and banks have the flexibility to custom-tailor a transaction to the commercial end-user’s business needs. Adoption of the rule as proposed would have an adverse effect on the current market practice and the ability of commercial end-users to manage their price risk. The Agencies ignore the commercial benefits of using non-cash collateral alternatives to cash margining, such as physical asset liens and letters of credit.

Derivatives transactions that hedge or mitigate commercial risk pose less risk. Generally, if a commercial end-user has to pay out under a hedge it meant that it likely had a positive outcome with respect to the risks it was hedging. Moreover, commercial end-users do not usually have off-setting derivatives positions with the same counterparty, and thus would not be able to take advantage of the netting requirements of SA-CCR that have been seen by the Agencies as an improvement over CEM.

If the rule is adopted as proposed, banks could limit their access to credit to commercial end-users, no longer allow non-cash collateral and require cash margining, or even withdraw from the commercial end-user derivatives market altogether. The rule as proposed would raise the costs of these transactions, and centralize risk that now is diversified according to the specific business needs of the commercial end-user. The increased capital costs that would result from adoption of the rule would inevitably be passed onto the commercial end-user by the bank and possibly thereafter by the commercial end-user to its own customers. If banks see commercial end-user derivatives transactions as no longer worth the increased costs, and leave the market, there will be fewer counterparties of that level of financial expertise with which a commercial end-user could engage in a derivatives transaction.

Cash margining would trap liquidity that could be better used in the commercial end-users’ business operations. With commercial end-user transactions, cash margining is impractical and economically inefficient. One commenter noted that cash margining is resource-intensive and would require both daily calculation of exposures, off-sets and cash balances, and significant daily reconciliation of margin calls and requests for return of margin against contractual requirements, internal policies and controls.

Many commenters saw the proposal as directly adverse to the Congressional intent expressed in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank exempted derivatives market end-users from clearing and uncleared derivative margin requirements. The current commercial end-user exemptions from the mandatory margin regulations for uncleared swap transactions are vital to the operations of commercial end-users. Adoption of the rule as proposed would directly undermine the use of the exemption.

Conclusion

The solution most often proposed was that the Agencies should exempt from SA-CCR banks’ derivatives transactions with commercial end-users when they are hedging their own commercial risks and are otherwise exempt from the mandatory margin requirements for uncleared swap transactions.

The comment period originally was supposed to end on Feb. 15, 2019, but has been extended until March 18, 2019, so it can be anticipated that more commercial end-users will be submitting their views to the Agencies. The proposal includes a transition period for compliance until July 2020, but that date likely will need to change depending upon when a final rule is issued.

While comments are welcome on all aspects of the proposal, the Agencies pose several questions for commenters to consider, including comments on “what other considerations relevant to the determination of whether to replace CEM with SA–CCR for advanced approaches banking organizations should the agencies consider,” a question that seems the ideal starting point for commercial end-users to use for their comments.

Kathleen A. Scott is a senior counsel in the New York office of Norton Rose Fulbright.