09 May 2014

Risk.net: Basel exposure limits raise questions for client clearing

The new limits, released by the Basel Committee on Banking Supervision, do not catch bank exposures to central counterparties (CCPs) - the original fear when the rules were proposed in March last year - although that is subject to an observation period that runs until 2016. But the regime does not exempt bank clients from counting the exposures they have to clearing members. The rules also state that exposures to two or more interconnected counterparties must be treated as a single exposure, and dealers warn that clearing members of the same CCP might be deemed interconnected because severe losses at a clearing house have the potential to hit all of its members.

"Is there an interconnectedness issue? There may well be", says one head of capital management at a European bank. "The fact they avoid commenting on it means – I think – they are trying to avoid painting CCPs into a position where clearing does not work. But it's not long ago that people were asking the same question about carve-outs for clearing members themselves."

The rules prohibit a bank from having any exposure greater than 25 per cent of its capital base to any single counterparty or connected counterparties. For exposures between global systemically important banks (G-Sibs), that limit is reduced to 15 per cent. In theory, a bank using a clearing member to access a CCP would be in more danger of hitting its limit, because its cleared business – potentially across multiple CCPs – would need to be added to any other counterparty exposure with that entity. The danger grows if other clearing members used by the bank would need to be added into the same total.

The high-level definition of interconnectedness requires at least one of two conditions to be satisfied – one entity has control over another entity, or financial problems at one would cause difficulties for the other. On the face of it, this second condition – economic interdependence – might apply to clearing members that share exposure to a CCP's default fund. If a member firm collapses and its own initial margin and default fund contributions are not enough to cover the loss, the CCP would turn to the rest of the default fund. If the fund is exhausted, members may be obliged to replenish it, which could conceivably be enough to put those firms under stress.

Bankers are hoping the regulators' apparent intent to protect clearing means member firms will not be deemed interconnected. "It's true that you could have banks that have a high correlation if you believe the CCP they are a member of is risky, or under some scenario could be risky, because they have commonality of default fund. But the fact they left out CCPs means I don't think there is a single supervisor out there that will consider common clearing membership to be economic interdependence," says a second head of capital management, this time at a North American bank.

Seven additional criteria provide some extra guidance, without settling the issue – one, for example, states entities would count as economically interdependent if "one counterparty has fully or partly guaranteed the exposure of the other counterparty, or is liable by other means"; a second says interdependence means "the financial problems of one counterparty would cause difficulties for the other counterparties in terms of full and timely repayment of liabilities".

More detail is not expected. Ultimately, the rules say, it will be up to individual supervisors to decide what counts as economic interdependence – if a bank can show that linked counterparties would be able to survive problems within the group, it may be allowed not to add up the exposure totals.

The Basel Committee document encourages jurisdictions to consider stricter limits for exposures between domestically systemically important banks, and exposures of smaller banks to G-Sibs. The new regime is set to be implemented from 1 January 2019.

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