A number of financial institutions have started to move assets off their balance sheet using different accounting treatments in an attempt to reduce their leverage and avoid high capital charges, officials said.
Basel III requires banks to hold sufficient capital to prevent a build-up of leverage on their balance sheet, which will ultimately have an impact on the global banking system. Kishore Ramakrishnan, director, financial services consulting at PwC Hong Kong, said that if a financial institution has high leverage, it risks not being able to service its debt and it also has a higher chance of going into a default and bankruptcy.
More Cash on Balance Sheet Means Higher Leverage Ratio
Under Basel III, banks will be required to maintain a high leverage ratio when they have more assets on their balance sheet. Leverage ratio is arrived at by taking the tier-1 capital over total exposures. Exposure capital is the sum of potential exposure of all future assets and replacement costs, according to Ramakrishnan.
"Regulators are trying to make the point that the higher the debt on banks' balance sheet, the higher the leverage and so the higher the capital charge. Regulators want banks to reduce leverage on the balance sheet," he said.
Shift from Cash to Non-Cash Collateral
Ramakrishnan said there is now a preference among banks to shift from cash to non-cash collateral so that assets can be taken off the balance sheet, thus reducing the amount of capital they are required to hold. A number of financial institutions have tried to move assets off their balance sheet using different accounting treatments in an attempt to reduce their leverage ratio and subsequently the amount of capital they are required to hold, he said.
Ramakrishnan said financial institutions have tried to explain to regulators that some of the assets on their balance sheets were held on clients' behalf and so should not be treated as a liability; those assets, they argued, should go into a separate, segregated account.
"This [holding of assets on behalf of clients] is true not only in the client-clearing world but also for bilateral trades. When financial institutions hold collateral [assets] from their counterparties, they are holding those assets to safeguard against the default of their counterparties, but when financial institutions put those collateral [assets] on their balance sheet, that's when Basel III kicks in," he said.
Separating Clients' Assets into a Segregated Account
Ramakrishnan said some financial institutions have begun the process of separating the assets they received from their clients as collateral into a third-party segregated account so that they will not be affected by the leverage ratio calculation.
Some financial institutions have argued that they are addressing credit and market risk concerns by exchanging initial and variation margin with their counterparties, and that the additional capital requirements in the form of leverage ratio for holding clients' assets on their balance sheet is "penalising them again". Banks are required to start exchanging initial and variation margin on January 1, 2018.
Initial and Variation Margin: New Regulatory Requirements
The new requirements for financial institutions to exchange initial and variation margin as part of the over-the-counter derivatives reforms have given rise to another concern: potentially insufficient collateral in the market for participants involved in OTC derivatives trades.
Regulators require market participants to exchange initial margin mainly to counter credit and default risks posed by their counterparties. Variation margin seeks to address market risk due to fluctuations in trade prices and market volatility, and it is therefore exchanged throughout the life of a swap.
Market participants usually post initial margin in the form of non-cash collateral, mainly securities. Variation margin, however, is predominantly in cash.
When a bank carries out a bilateral trade and posts, say, a particular bond as collateral, that collateral is locked in with a custodian, Ramakrishnan said.
"All the rules stipulate that banks have to separate the collateral with a third-party custodian. Unless market participants have enough volume, there are not many market participants who can find alternative assets to post as initial or variation margin," he said.
Dearth of Liquid Sovereign Bonds in Asia
When a market participant uses a particular bond to pay initial margin, it is not allowed to rehypothecate that asset for future transactions. The restrictions now on rehypothecation, which no longer allow market participants to reuse collateral for new OTC derivatives transactions, have further exacerbated the issue about insufficient eligible collateral in the market.
The issue is more pronounced in Asia due to the dearth of liquid sovereign bonds which can be considered eligible collateral, said Andrew Pal, consultant at DerivAsia in Singapore. Singapore government bonds – which are accepted only by the Singapore Exchange – and Thai government bonds, for example, are not considered eligible collateral by most central counterparties (“CCPs”) based on current market practice, he said.
Japanese Government Bonds the only Eligible Collateral in Asia
Aside from Japanese government bonds, none of the sovereign bonds in Asia are recognised as eligible collateral by market participants, said Ramakrishnan. Even if a sovereign bond is highly rated, if it is not sufficiently liquid, it would be impossible for market participants to post such sovereign bond as initial margin, he said.
"You have to look at the volume of sovereign bonds that is available in the respective markets that can be used as initial and variation margin," he said.
Some market sources pointed to Singapore government bond as an example, which they said, despite its high ratings compared with other sovereign bonds in the region, is still not as widely accepted as collateral because it is considered not sufficiently liquid.
Paradox More Prominent in Asia
Pal said the paradox is more prominent in Asia because of the smaller pool of collateral in this region compared with Europe and the U.S., and fewer market participants in OTC derivatives and futures clearing. The problem is further compounded by the fact that CCPs in this region do not recognise the sovereign bonds in each other's jurisdictions as eligible collateral, apart from Japanese government bonds and U.S. Treasuries.
"CCPs should work together to recognise the collateral in each other's jurisdictions. Singapore Exchange for example, has been lobbying other CCPs to accept Singapore government bonds as eligible collateral," he said.
Pal also pointed to another problem which is that of infrastructure. Market participants in Asia use mainly cash as collateral. He said buy-side such as asset managers is currently not prepared to use non-cash collateral and neither does it have the infrastructure not to use cash which is not in line with global best practice. "Asset managers don't have the operational infrastructure nor back office experience," he added.
CCPs, on the other hand, have not yet considered non-cash collateral to be a scalable alternative, Pal said.