Saturday, April 9, 2011

Two Major Tests for Bank Regulators

As I said in my previous post, the new Basel III liquidity requirements are a massive deal, and one of the most important aspects of financial reform, but have been almost completely ignored by commentators as well as the press. As a result, I think it would be useful for me to highlight the most important aspects of the new liquidity requirements that were left to national regulators — and that therefore are still up in the air. I’m only going to address the Liquidity Coverage Ratio (LCR) here, since the other component of the liquidity requirements, the Net Stable Funding Ratio, isn’t scheduled to be implemented until 2018, if it’s ever implemented at all (and I have serious doubts about whether it’ll ever be implemented in anything like its current form, which is barely even coherent).

Broadly, the Liquidity Coverage Ratio requires internationally active banks to maintain a stock of “high-quality liquid assets” that’s sufficient to cover cash outflows in a 30-day stress scenario. In other words, banks are required to have enough cash or cash-like instruments on hand to survive a really horrible, financial-crisis-level 30 days, in which the funding markets all but shut down. The cash outflows in the stress scenario are calculated by applying “run-off rates” to each source of funding (e.g., unsecured wholesale funding, repos, etc.). Most of the action/controversy here is in the different run-off rates used. (I gave a more detailed explanation of the LCR here and here.)

There are, in my opinion, two major issues that still have to be determined by national regulators: (1) the run-off rate for market valuation changes on derivatives transactions; and (2) the definition of, and run-off rate for, so-called “non-contractual contingent funding obligations.” This post will address the first issue. My next post will deal with the second issue (which I’ve come to the conclusion should absolutely be called “the Citigroup rule”).

Market valuation changes on derivatives transactions

The final Basel III document amazingly contains only three sentences on this issue:

Increased liquidity needs related to market valuation changes on derivative or other transactions: (non-0% requirement to be determined at national supervisory discretion). As market practice requires full collateralisation of mark-to-market exposures on derivative and other transactions, banks face potentially substantial liquidity risk exposures to these valuation changes. Inflows and outflows of transactions executed under the same master netting agreement can be treated on a net basis.
To use a familiar example that most people understand, this is the liquidity risk that brought down AIG’s CDS book. AIG entered into CDS contracts which required it to post collateral when the market value of the underlying CDOs fell. By entering into these CDS contracts, AIG took on massive liquidity risk — that is, AIG was exposed to the risk that the market valuation of the underlying CDOs would fall, requiring it to come up with cash to post as collateral. If AIG had been subject to Basel III’s new liquidity rules, it would’ve been required to hold additional “high-quality liquid assets” in its liquidity pool to cover the potential collateral calls.

So what regulators have to determine here is basically how far market valuations on derivatives can fall during a 30-day financial crisis. If the regulators say that market values on, say, the CDX IG contract (a popular index CDS tracking investment-grade corporate bonds) would fall 20% in the 30-day stress scenario, then that’s a 20% run-off rate for CDX IG protection sellers. Obviously, there will have to be different assumptions on market value changes for different products — e.g., the price of high-yield debt would almost certainly fall much further than the price of investment-grade debt in a crisis, so banks that sold protection on the CDX HY contract would experience much greater cash outflows than banks that sold protection on the CDX IG contract. Interest-rate swaps will presumably need different assumptions too — Libor’s volatility, for instance, played havoc with rate swap valuations after Lehman failed.

(Oddly though, the language of the Basel III document suggests that banks that would benefit from market valuation changes on derivatives wouldn’t get to count those cash inflows unless those derivatives were executed under a master agreement with other derivatives that would suffer from the market valuation changes. They couldn’t be counted under any of the separately-defined “Cash Inflows” categories, so the only way those inflows could be counted is if they’re netting off outflows under a master agreement. Personally, I doubt this is what the Basel Committee intended, so I’m expecting this to change when the regulators get into the rulemaking process.)

The reason this is so important is that when you get to the dealer bank level, large market value changes can cause a lot of money to change hands, and if a dealer isn’t running a very flat (i.e., market-neutral) book, it can suffer significant cash outflows. Just ask Morgan Stanley.

Not only are the levels that regulators set here extremely important to the robustness of the liquidity requirements, but they’ll also provide a unique insight into the kind of crisis that regulators think banks should be able to withstand — and, also, into how seriously the regulators are taking the job of writing regulations to prevent another financial crisis.

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