06 December 2013

Fitch: Basel III to keep bank market, counterparty risk low

European bank trading and counterparty risk exposure is likely to remain relatively low in 2014 as Basel III's more conservative regulatory regime helps stifle bank risk appetite, says Fitch Ratings.

Recent proposals to revise trading book capital requirements might also cause banks to limit market risk activities until these rules are bedded down.

Fitch believes risk tolerance may pick up again as banks search for earnings growth beyond 2014. However, Basel's stricter rules are likely to continue to result in a capital constraint on trading and counterparty risk exposure. This could drive some of these activities to other parts of the financial system. 

In a recent Fitch study, the 16 European institutions designated as global systemically important banks (G-SIBs) reduced their counterparty risk exposure by almost 20 per cent in 2012. These reductions partly reflect efforts to reduce over-the-counter derivatives exposure in the face of Basel III's explicit push to shift more of this trading to central clearing counterparties (CCP).

Counterparty exposure could continue to drop as mandatory clearing takes effect and as the range of products that can be centrally cleared and the number of authorised CCPs increase. The Financial Stability Board's latest progress report found that around 42 per cent of OTC interest rate derivatives and 14 per cent of OTC credit derivatives were centrally cleared as at end-June, a slight rise from its previous report. 

The recognition of bilateral netting for derivatives in the proposed Basel III leverage ratio calculation could increase the incentives for banks to use netting agreements that meet regulatory requirements, which should also reduce measured counterparty exposure. For reverse repos, the proposed leverage ratio does not permit netting, which, relative to the risk-based requirements, would likely result in higher capital charges for these and other securities financing transactions. Fitch expects that banks will continue to curtail their repo activities in anticipation of this requirement, unless it is amended, which is another reason it expects counterparty exposure to decline.

In terms of market risk, the introduction of Basel 2.5 contributed to a more than 50 per cent increase in our sample banks' market-risk capital in 2011, the implementation year. This requires banks to add a "stressed" value-at-risk (VaR) measure to its existing VaR results, among other changes. 

During 2012, several banks aggressively pared back their trading book activities, contributing to a 24 per cent net reduction in market risk capital usage over that timeframe. These trends were consistent with the strategic efforts by several banks to scale back their capital markets activities in order to reduce regulatory capital requirements.

Fitch expects the European banks to continue to manage their market risk exposure tightly, particularly in fixed income, while the Basel Committee's trading book rules are finalised. A second consultative document on the fundamental review of trading book capital requirements was published 31 October for consultation until end-January 2014. The shift to using an expected shortfall approach instead of VaR, a stricter boundary between the trading and banking books, increasing capital requirements for market illiquidity and revisions to the treatment of credit would all have implications for market risk capital and could reshape trading books further.

These trends might lead to further consolidation of trading activities amongst the global trading banks, which are looking for scale, liquidity and adequate profitability on the capital they need to allocate in their chosen asset class businesses, and exiting areas where this is not achievable. Fitch would expect to see some return of risk appetite at trading banks once the competitive landscape has settled following the implementation of regulatory and market reforms, but the boundaries being set are likely to keep this largely in check. 

Press release

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