Chen Xu, associate at Debevoise & Plimpton, offers an overview of the regulatory agenda impacting the securities finance industry in the US.
Last year, the highlight of President Trump’s financial regulatory agenda was passage of the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA), which mandated that the US federal bank regulators scale back certain elements of their post-crisis regulatory regime. In the second half of 2018 and the first half of 2019, these regulators have been working to execute their Congressional mandate, culminating in a set of proposals to tailor their prudential framework for large US and foreign banking organizations.
Although these proposals provide significant, targeted relief for some firms, these proposals represent a tailoring of requirements rather than a wholesale reduction. In particular, US federal bank regulators remain focused on ensuring that the largest and most complex firms remain subject to a robust prudential framework, particularly with respect to their securities financing transaction (SFT) activities. This tension between regulatory tailoring and a special focus on certain core areas of prudential regulation will be a key theme of this coming year.
Impact of EGRRCPA and tailoring proposals on SFTs
Prior to adoption of the EGRRCPA in 2018, the original 2010 version of the Dodd-Frank Act required federal regulators to adopt enhanced prudential standards for all banking organizations with $50 billion or more in total consolidated assets. The EGRRCPA raised this threshold to $250 billion, but gave the federal bank regulators the ability to further tailor standards for firms with at least $100 billion, but less than $250 billion in assets based on their capital structure, riskiness, complexity, financial activities, size and other risk-related factors.
The tailoring proposals published by the federal bank regulators implement this new framework by creating four categories of prudential standards for firms with $100 billion or more in the assets. Category I firms include the US global systemically important banks (GSIBs). Category II firms include firms with $700 billion or more in assets or $75 billion or more in cross-jurisdictional activity, and includes the foreign GSIBs most active in the US. Category III firms include firms with $250 billion or more assets or at least $75 billion in one of: nonbank assets, short-term wholesale funding or off-balance sheet exposure. Category IV firms include all other firms with $100 billion or more in assets. For foreign firms, the relevant thresholds would be measured with respect to their US operations or US intermediate holding company, as applicable.
The proposals would significantly reduce prudential requirements for firms in Categories III and IV, but would largely retain the requirements for firms in Categories I and II. For many foreign firms operating in the US, the proposals would even impose new quantitative liquidity requirements on their US intermediate holding companies, including liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) requirements. The LCR requires firms to hold a buffer of high quality liquid assets to cover potential net cash outflows over a 30 day stress scenario. The NSFR requires firms to fund their longer term and less liquid assets with stable funding in the form of “sticky” deposits, medium/long-term debt and regulatory capital. Each of the LCR and NSFR are designed to penalize short-term wholesale funding, including overnight cash obtained from, and provided in connection with, SFTs.
Previously, US intermediate holding companies of foreign banking organizations that did not own a US depository institution were not subject to the LCR or NSFR. This provided the US broker-dealer arms of certain foreign banks with a comparative funding advantage to US firms. If adopted as formulated, the proposals could place increased pressure on these foreign firms to reduce their reliance on short-term wholesale funding and impair their access to US dollar funding generally, which could be at odds with their business strategies in the US.
Even the framing of the categories themselves could have a significant influence on US SFT activity. For example, a key inflection point in the four category system is the level of a firm’s weighted short-term wholesale funding, which includes to varying degrees funding obtained from SFTs with maturity of one year or less. Another key inflection point is nonbank assets, which would include SFT assets (receivables) held by US broker dealers. Yet another inflection point is off-balance sheet exposure, which would include borrower default indemnification provided by securities lending agents. Firms seeking to avoid a particular category or specific requirements could be incentivized to scale back their SFT activities in order to fall below one of the relevant thresholds.
On the other hand, one of the most significant positive changes contemplated by EGRRCPA has resulted in a proposal to amend the supplementary leverage ratio (SLR) denominator to exclude the fiduciary, custody and safekeeping funds of certain firms deposited with central banks if the firm is predominately engaged in custody, safekeeping and asset servicing activities. This change is particularly relevant for SFT activities, as many types of principal-based SFT activity (e.g. repo bond financing repo) relies heavily on balance sheet usage, which is constrained by the SLR. Currently, this relief would apply to The Bank of New York Mellon Corporation, State Street Corporation and Northern Trust Corporation. Allowing these firms to exclude this type of cash from their SLR denominator would significantly free up their balance sheets to engage in additional SFT activities.
Pending implementation of Basel Committee frameworks
At the international level, the Basel Committee on Banking Supervision (Basel Committee) announced in December 2017 that it finalized all outstanding reforms under its Basel III framework. Although the US has yet to even propose regulations implementing the Basel III finalization, the breadth and potential impact of the changes has caused a significant amount of regulatory uncertainty as firms engage in business planning.
The specific changes that directly impact SFTs include the introduction of a more risk-sensitive standardized methodology for measuring the potential future exposure for SFTs. The pre-revision Basel III framework (and the current US regulatory capital rules) requires firms to measure their potential future exposure to SFTs using the “comprehensive approach” (or “collateral haircut approach”). The primary criticism of this approach is that it does not recognize the risk mitigating benefit of correlations between long and short positions or of the effect of portfolio diversification. Consequently, the capital charges associated with the comprehensive approach can be up to 30-50 times higher than those required by a firm’s regulator-approved internal models. The Basel Committee’s revised comprehensive approach attempts to address the perceived defects of the current approach by modifying the calculation to address these two criticisms. Although pro forma analysis suggests that the revised approach would still be more stringent than any internal model, the revised approach would represent an improvement over the current comprehensive approach, resulting in significantly lower exposure amounts (and therefore lower capital requirements).
This change is of particular significance in the US, where even firms that are permitted to use internal models to calculate their exposures to SFTs must also calculate their exposures under the standardized collateral haircut approach. In addition, many aspects of the US regulatory framework outside of the capital rules measure credit exposure to SFTs by reference to the collateral haircut approach (e.g. the single-counterparty credit limits). Consequently, implementation of the revised comprehensive approach would not only provide significant capital benefits to firms in the US, but would also have positive ripple effects on other, related requirements. On the other hand, failure to implement the revised comprehensive approach in the US could place US firms at a significant disadvantage to firms in jurisdictions that did adopt the revisions.
Another significant change to the Basel III framework is the introduction of a capital charge that would impose minimum haircuts for non-centrally cleared SFTs. In particular, the minimum haircuts would apply to non-centrally cleared securities financing transactions in which financing (lending of cash) against collateral (other than government securities) is provided to counterparties who are not supervised by a regulator that imposes Basel-style prudential requirements. The framework would also apply to so-called collateral upgrade transactions with such counterparties where a bank lends a security to its counterparty and the counterparty pledges a lower quality security as collateral. Transactions that did not meet the minimum collateral haircuts would be required to be treated as uncollateralized, significantly increasing the capital requirements associated with those transactions.
Although the rule includes significant exclusions, including for more “traditional” types of cash collateralized securities lending transactions, and although the minimum haircuts are largely consistent with current market standards, the possibility of significantly higher capital requirements could increase SFT transaction costs as market standard collateral practices evolve and could incentivize firms to centrally clear their securities financing activities.
Outstanding US reforms
Other proposals that have remained outstanding since last year that could have a significant impact on securities financing activity in the US include a proposal to implement the NSFR, a Federal Reserve and OCC proposal to revise the enhanced supplementary leverage ratio (eSLR) applicable to GSIBs and their insured depository institution subsidiaries, a “stress capital buffer” proposal to incorporate the results from the Federal Reserve’s CCAR program into the capital rules (via the capital conservation buffer) and proposed changes to the regulations implementing the Volcker Rule.