The financial crisis exposed some weaknesses in how derivatives are traded and managed. A lack of reporting meant there was uncertainty over who had what exposures, which undermined confidence and the willingness to extend credit.
The bilateral nature of the market meant there was a network of interlinking trading relationships, with the big dealers at the center, which led to fears of contagion. While many of those bilateral trades were collateralized, some weren’t. Even where they were, there were questions about the frequency of collateral calls and the ability to quickly access that collateral in the event of a default.
On top of all that, banks were found to have insufficient capital or liquidity to withstand a severe market shock.
Regulators and the industry have spent the past eight years addressing those issues. Reporting of all derivatives trades is now required virtually everywhere, and regulators have ready access to that information in their own markets. Clearing of standardized derivatives has quickly gained traction, and now about three quarters of interest rate derivatives notional outstanding is cleared through a central counterparty. Margin requirements are being rolled out for non-cleared transactions. And the largest global banks have raised more than $1.5 trillion in new capital.
The financial system is more resilient as a result. Just think back on what’s happened over the past two years. We’ve seen a succession of shock events – Brexit, the US elections, the unpegging of the Swiss franc, and Ukraine and Crimea. These events have been accompanied by sudden, violent and sometimes unprecedented moves in markets.
ISDA is leading industry efforts to agree a common interpretation of the requirements, and to map out a practical way of applying them. The ultimate aim is to pool data across the industry, enabling banks to fill the gaps in their own data. But there’s some question over whether regulators will endorse a data pooling solution as part of FRTB compliance.
This will be crucial. It’s difficult to see how internal models for market risk will work without some form of industry data pooling. Without it, a large universe of risk factors might not qualify for inclusion in internal models, which will result in higher capital requirements. In fact, an ISDA impact study last year showed that non-modellable risk factors comprise a whopping 35% of the internal models approach capital charge.
Both of these measures chip away at the risk sensitivity of the capital framework. And they’re not the only ones. They come on top of the leverage ratio – meant as a non-risk-sensitive backstop to capital requirements – and the proposal to introduce output floors.
The former is increasingly becoming the primary driver for bank capital, rather than being a backstop. Here in Europe, for example, the EBA has reported that the leverage ratio acts as a primary constraint for 75% of the largest banks.
That’s having a noticeable impact on bank behavior already. Certain low-risk, low-return businesses – repo, for instance – are becoming less economic given the level of capital that institutions have to hold, meaning some banks are pulling back from that product. Essentially, the level of capital is no longer appropriate to the risks posed by this business.
ISDA strongly believes the capital framework should be risk-sensitive, appropriate and coherent. Crucially, it should aim to avoid any detrimental impact on market liquidity, and ensure banks are able to continue to lend to the real economy and provide crucial hedging products to end users. As pointed out in the video we watched earlier, providing financing and risk management services helps set the foundations for economic growth.
The EU is so far the only major jurisdiction to publish a draft proposal for implementing the remaining Basel rules. Those proposals contain targeted amendments to the Basel measures that recognize the role banks play in financing the economy, as well as the need for consistency between market and prudential reforms.
Full speech
© ISDA - International Swaps and Derivatives Association
Key
Hover over the blue highlighted
text to view the acronym meaning
Hover
over these icons for more information
Comments:
No Comments for this Article