America
27 November 2012
The US is putting the breaks on certain reforms in response to fears that financial institutions are not prepared for their implementation in 2013, as SLT finds out
Image: Shutterstock
After Hurricane Sandy battered the East coast and President Barack Obama won a hard-fought election to overcome Republican presidential candidate Mitt Romney, the US could be forgiven for needing to take a breather.
And take one it did. On 9 November, the US Treasury said that it would not be implementing Basel III rules on 1 January 2013 because financial institutions would not be ready to meet tougher capital standards.
Basel III increases financial institutions’ common equity holding of risk-weighted assets from 2 percent to 7 percent, and demands improved risk coverage for complex illiquid trading activities.
“Many industry participants have expressed concern that they may be subject to a final regulatory capital rule on January 1, 2013, without sufficient time to understand the rule or to make necessary systems changes,” said the US Treasury, without specifying a new implementation date.
A delay to the implementation of Basel III rules comes after US regulators received nearly 1500 comment latters on three notices of proposed rulemaking that would help to implement the new Basel capital rules as well as certain aspects of the US Dodd-Frank Act.
Speaking at the 15th Annual International Banking Conference in Chicago on 16 November, Mary Miller, the US Treasury’s under secretary for domestic finance, noted the delay to the implementation of Basel III and aspects of Dodd-Frank and that regulators offered assurances that financial institutions will have time to transition after the rules take effect.
She said: “In the meantime, our banking agencies should work closely with their international counterparts towards Basel III implementation. Currently, only eight of the 27 Basel committee members have issued final Basel III regulations. US banking regulators should be mindful of divergences with their international peers, which may lead to regulatory arbitrage and uncertainty on the part of firms trying to manage capital resources. In addition, we encourage our international counterparts to implement the Basel III leverage ratio to ensure that there is a simple backstop against excessive risk and to promote a level playing field.”
The securities lending industry has been highly critical of both Basel III and Dodd-Frank, arguing that they would severely restrict the industry’s ability to conduct business.
Nicholas Bonn, executive vice president and head of securities finance and portfolio solutions at State Street, says that the punitive effects of these regulations are worrying borrowers and agent lenders more than beneficial owners, who are “not too fussed about it”.
“The proposed implementation of Section 165(e) of the Dodd-Frank Act is concerning to both agent lenders and borrowers, with respect to credit concentration and the proposed implementation of the Basel III capital agreement, which could limit the ability of agency lenders to provide indemnified securities lending due to higher capital requirements. But we believe that indemnification will continue to be offered, though it may be viewed as a premium product feature and priced accordingly in the future.”
Bonn says that this is representative of beneficial owners’ confidence in their agent lenders, and that he is not seeing a lack of enthusiasm for doing business in the US.
He explains: “We’ve built up a gradual confidence in our client base, but they are watchful and risk averse. Beneficial owners understand that we’re doing securities lending in an uncertain market environment, particularly with all that’s going on in Europe, but we haven’t seen a lack of enthusiasm for lending, it’s just a far more cautious approach with risk management at the forefront.”
The industry’s position on the onslaught of regulation that has followed the financial crisis has not always been negative, and it has in fact embraced some reforms.
Reform of the US triparty repo market is well underway, with financial institutions, such as J.P. Morgan, working towards completion of the Phase Two Target End State as agreed with the Federal Reserve Bank of New York, by the end of 2013.
A key component of the reform was to align the settlement of trades, so that one large initial batch is confirmed and funded by 3.30pm, and additional smaller batches are settled continuously thereafter as needed.
Mark Trivedi, managing director at J.P. Morgan Worldwide Securities Services, was a member of the Federal Reserve Bank of New York’s Triparty Repo Infrastructure Task Force that worked to define and achieve the “target state” of a safer and more robust settlement process for the triparty repo market that would not rely on significant discretionary intraday credit.
He says: “Today, even without moving any further, we’ve changed the dynamic of that risk alignment, so that cash investors are holding collateral for the full trading day—until 3.30pm—and that’s a big change. No longer unwinding at the start of the day means that they are secured with defined collateral versus concentrated unsecured depositor risk with the clearing agents. In the past, the full exposure was with the clearing agents. There’s a population of cash lenders that may not have understood those nuances, so having the risks properly aligned and making sure they’re properly sensitive to those risks has been a significant change.”
He adds: “Now we’re starting to see the impact in the decisions that they make about the way that they invest collateral—the change in the distribution of high quality collateral. Prior to the implementation of reforms, we had about a 60 / 40 split, meaning that 60 percent was Fed-eligible, 40 percent was DTC—this being the lesser quality, less liquid collateral. Today, we’re at about 86 percent Fed and 14 percent DTC. It’s a tremendous change over the last several years. What that highlights is lenders and dealers have become more aware of the risks inherent in the triparty collateral and are moving towards better quality collateral.”
Acclimatise or be surprised
Changes have occurred in US securities lending in the prolonged aftermath of the financial crisis. One is the agent lender / beneficial owner relationship, which evolved as a need for greater transparency developed. Mark Payson, managing director at Brown Brothers Harriman, says that agent lenders are providing additional transparency, primarily because of a desire from beneficial owners rather than mandates from regulators.
He says: “Many beneficial owners already had transparency into how their programmes were managed. But now it’s become clear that it is the beneficial owner’s fiduciary responsibility to maintain ultimate oversight of their programmes, and the agent lender’s responsibility to make sure that we deliver them the level information that allows them to conduct those responsibilities. This has meant that more transparency is now industry standard.”
Another change is that broker-dealers’ demand for exclusives, and beneficial owners’ appetite to participate in them, is still “well below the highs” of 2007 and 2008, notes Payson, but there are certain assets showing a positive trend.
He explains: “There still hasn’t been a broad improvement in the demand for exclusives. We are seeing demand from broker-dealers for certain US equity exclusives, and we’re starting to see the premiums for those escalate a little bit, particularly the Russell 2000 or other small-cap US equities, but it hasn’t really extended further.”
“I think the recent activity is driven by broker-dealers looking to dampen some of the rate volatility and velocity that has been in the market for the last few years. Agent lenders are aggressively re-rating loans for their clients on a daily basis. Entering into an exclusive or paying a premium for certain assets may be more expensive for the borrower, but it allows them to lock in their costs of funding instead of being subject to the continuous re-rate process.”
The increased frequency of rate changes is the result of lower returns and fewer opportunities, says Payson. “Returns are down, there is virtually no opportunity to increase returns through cash collateral reinvestment, and there are fewer specials than there were when markets were stronger, so most agents lenders are focused on a smaller subset of securities in order to generate returns. This just increases the velocity of the rate changes.”
He says: “Overall, beneficial owners are looking at ways to generate additional returns, but they’re reviewing these cautiously. I think as a rule beneficial owners are open to either exclusives or traditional discretionary agency lending, or a hybrid of the two, but ultimately the determination of route to market should be a client-by-client conversation depending on their asset mix and risk profile.”
As the US settles down for another four years of Obama, conservative fears of further federal intervention in financial markets will increase. But the securities lending industry has proven to be adaptable and capable of taking the rough with the smooth, while regulators are listening to financial institutions, which are not ready for a 2013 of Basel III and Dodd-Frank implementation. Time, as ever, will tell.
And take one it did. On 9 November, the US Treasury said that it would not be implementing Basel III rules on 1 January 2013 because financial institutions would not be ready to meet tougher capital standards.
Basel III increases financial institutions’ common equity holding of risk-weighted assets from 2 percent to 7 percent, and demands improved risk coverage for complex illiquid trading activities.
“Many industry participants have expressed concern that they may be subject to a final regulatory capital rule on January 1, 2013, without sufficient time to understand the rule or to make necessary systems changes,” said the US Treasury, without specifying a new implementation date.
A delay to the implementation of Basel III rules comes after US regulators received nearly 1500 comment latters on three notices of proposed rulemaking that would help to implement the new Basel capital rules as well as certain aspects of the US Dodd-Frank Act.
Speaking at the 15th Annual International Banking Conference in Chicago on 16 November, Mary Miller, the US Treasury’s under secretary for domestic finance, noted the delay to the implementation of Basel III and aspects of Dodd-Frank and that regulators offered assurances that financial institutions will have time to transition after the rules take effect.
She said: “In the meantime, our banking agencies should work closely with their international counterparts towards Basel III implementation. Currently, only eight of the 27 Basel committee members have issued final Basel III regulations. US banking regulators should be mindful of divergences with their international peers, which may lead to regulatory arbitrage and uncertainty on the part of firms trying to manage capital resources. In addition, we encourage our international counterparts to implement the Basel III leverage ratio to ensure that there is a simple backstop against excessive risk and to promote a level playing field.”
The securities lending industry has been highly critical of both Basel III and Dodd-Frank, arguing that they would severely restrict the industry’s ability to conduct business.
Nicholas Bonn, executive vice president and head of securities finance and portfolio solutions at State Street, says that the punitive effects of these regulations are worrying borrowers and agent lenders more than beneficial owners, who are “not too fussed about it”.
“The proposed implementation of Section 165(e) of the Dodd-Frank Act is concerning to both agent lenders and borrowers, with respect to credit concentration and the proposed implementation of the Basel III capital agreement, which could limit the ability of agency lenders to provide indemnified securities lending due to higher capital requirements. But we believe that indemnification will continue to be offered, though it may be viewed as a premium product feature and priced accordingly in the future.”
Bonn says that this is representative of beneficial owners’ confidence in their agent lenders, and that he is not seeing a lack of enthusiasm for doing business in the US.
He explains: “We’ve built up a gradual confidence in our client base, but they are watchful and risk averse. Beneficial owners understand that we’re doing securities lending in an uncertain market environment, particularly with all that’s going on in Europe, but we haven’t seen a lack of enthusiasm for lending, it’s just a far more cautious approach with risk management at the forefront.”
The industry’s position on the onslaught of regulation that has followed the financial crisis has not always been negative, and it has in fact embraced some reforms.
Reform of the US triparty repo market is well underway, with financial institutions, such as J.P. Morgan, working towards completion of the Phase Two Target End State as agreed with the Federal Reserve Bank of New York, by the end of 2013.
A key component of the reform was to align the settlement of trades, so that one large initial batch is confirmed and funded by 3.30pm, and additional smaller batches are settled continuously thereafter as needed.
Mark Trivedi, managing director at J.P. Morgan Worldwide Securities Services, was a member of the Federal Reserve Bank of New York’s Triparty Repo Infrastructure Task Force that worked to define and achieve the “target state” of a safer and more robust settlement process for the triparty repo market that would not rely on significant discretionary intraday credit.
He says: “Today, even without moving any further, we’ve changed the dynamic of that risk alignment, so that cash investors are holding collateral for the full trading day—until 3.30pm—and that’s a big change. No longer unwinding at the start of the day means that they are secured with defined collateral versus concentrated unsecured depositor risk with the clearing agents. In the past, the full exposure was with the clearing agents. There’s a population of cash lenders that may not have understood those nuances, so having the risks properly aligned and making sure they’re properly sensitive to those risks has been a significant change.”
He adds: “Now we’re starting to see the impact in the decisions that they make about the way that they invest collateral—the change in the distribution of high quality collateral. Prior to the implementation of reforms, we had about a 60 / 40 split, meaning that 60 percent was Fed-eligible, 40 percent was DTC—this being the lesser quality, less liquid collateral. Today, we’re at about 86 percent Fed and 14 percent DTC. It’s a tremendous change over the last several years. What that highlights is lenders and dealers have become more aware of the risks inherent in the triparty collateral and are moving towards better quality collateral.”
Acclimatise or be surprised
Changes have occurred in US securities lending in the prolonged aftermath of the financial crisis. One is the agent lender / beneficial owner relationship, which evolved as a need for greater transparency developed. Mark Payson, managing director at Brown Brothers Harriman, says that agent lenders are providing additional transparency, primarily because of a desire from beneficial owners rather than mandates from regulators.
He says: “Many beneficial owners already had transparency into how their programmes were managed. But now it’s become clear that it is the beneficial owner’s fiduciary responsibility to maintain ultimate oversight of their programmes, and the agent lender’s responsibility to make sure that we deliver them the level information that allows them to conduct those responsibilities. This has meant that more transparency is now industry standard.”
Another change is that broker-dealers’ demand for exclusives, and beneficial owners’ appetite to participate in them, is still “well below the highs” of 2007 and 2008, notes Payson, but there are certain assets showing a positive trend.
He explains: “There still hasn’t been a broad improvement in the demand for exclusives. We are seeing demand from broker-dealers for certain US equity exclusives, and we’re starting to see the premiums for those escalate a little bit, particularly the Russell 2000 or other small-cap US equities, but it hasn’t really extended further.”
“I think the recent activity is driven by broker-dealers looking to dampen some of the rate volatility and velocity that has been in the market for the last few years. Agent lenders are aggressively re-rating loans for their clients on a daily basis. Entering into an exclusive or paying a premium for certain assets may be more expensive for the borrower, but it allows them to lock in their costs of funding instead of being subject to the continuous re-rate process.”
The increased frequency of rate changes is the result of lower returns and fewer opportunities, says Payson. “Returns are down, there is virtually no opportunity to increase returns through cash collateral reinvestment, and there are fewer specials than there were when markets were stronger, so most agents lenders are focused on a smaller subset of securities in order to generate returns. This just increases the velocity of the rate changes.”
He says: “Overall, beneficial owners are looking at ways to generate additional returns, but they’re reviewing these cautiously. I think as a rule beneficial owners are open to either exclusives or traditional discretionary agency lending, or a hybrid of the two, but ultimately the determination of route to market should be a client-by-client conversation depending on their asset mix and risk profile.”
As the US settles down for another four years of Obama, conservative fears of further federal intervention in financial markets will increase. But the securities lending industry has proven to be adaptable and capable of taking the rough with the smooth, while regulators are listening to financial institutions, which are not ready for a 2013 of Basel III and Dodd-Frank implementation. Time, as ever, will tell.
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