Banks hope for CCP capital concessions at Basel meeting

Long-awaited rules on bank capital requirements for clearing house exposures are expected this month, with the industry hoping for a softening of the current exposure method (CEM) that appeared in two sets of earlier proposals from the Basel Committee on Banking Supervision. Dealers claim that approach – used to work out how much capital banks should hold against their contributions to clearing house default funds – would make it unattractive to provide client clearing services, in which firms that are not members of a central counterparty (CCP) clear their trades through an intermediary.

The head of over-the-counter clearing at one large US bank describes the issue as his number one priority. "Regulators are supposed to be creating incentives for firms to clear. But where are they? We're not seeing them," he complains. One or two clearing members that had initially been vocal about plans to offer client clearing have recently gone quiet – possibly a sign that they are waiting to see whether it makes commercial sense as a business, he speculates.

CCPs share the concern, but are hopeful that 18 months of lobbying will pay off – the CEM approach was first proposed in December 2010. "We have the impression that the Basel Committee realises the proposals are inappropriate. The question is what to do about it," says Rory Cunningham, public affairs director at LCH.Clearnet.

Under the proposals as they stand, CCPs will use CEM to come up with a hypothetical capital figure by adding up their counterparty exposures to all clearing members, subject to a strict limit on the amount of netting allowed. Actual capital requirements for member firms' default fund contributions are then calculated by comparing the CCP's financial resources, in terms of margin, default funds and its own capital, to the hypothetical figure. Put simply, the idea is to work out how strong a CCP ought to be, and charge capital based on how strong it actually is – the resulting risk-weights applied to default fund exposures can range from 1.6% to 120%.

But the CEM is the most basic way of calculating credit exposures and has been borrowed from existing bank capital rules. When applied to a CCP, dealers say it is overly simplistic and does not reflect the benefits of multilateral netting. A second draft of the rules released in November last year tweaked the CEM to allow greater netting but dealers claim it did not go far enough.

We have the impression that the Basel Committee realises the proposals are inappropriate. The question is what to do about it

The industry now expects more change, claiming a delay in the release of the final rules – originally expected in March – indicates the CEM will be delayed or softened.

"I would say we are more confident now that the Basel Committee has listened to the industry's concerns and is working constructively to find ways of preventing unintended consequences where the capital cost of trading through a qualifying CCP could be more than trading through a non-qualifying CCP or trading bilaterally. I think they appreciate these significant and material concerns," says Peter Sime, head of risk and research at the International Swaps and Derivatives Association.

Regulators are thought to be discussing the new rules at the Basel Committee's current two-day meeting – which concludes today – with rules expected to be published by June 30, giving the industry six months to comply before the Group of 20 (G-20) deadline of end-2012 for the clearing of all standardised OTC derivatives.

During the week beginning May 28, industry representatives met with the risk measurement group (RMG) of the Basel Committee – which is responsible for writing the rules – to discuss alternatives to the CEM. Proposals presented by Isda offer two suggestions to the Basel Committee: the first being postponement of the charge, with an observation period instead being used to make sure the new measure produces a sensible capital level; the second being a gradual introduction of CEM over an extended period of time.

"The recommendation of the industry was, if you are not required by the G-20 timelines to put a capital rule in place by January 2013, go into an observation period to test different methodologies," says Mark White, senior vice-president of capital management and optimisation at the Bank of Montreal (BMO) in Toronto and one of the authors of Isda's presentation.

"That may not be possible because of the G-20 requirement that things get done by the start of 2013. So, if regulators can't do that, then proceed with CEM on a recalibrated basis and put it in via a gradual transition period – so you get the information by requiring the calculations, but you're not going to do any damage while CCPs are still developing. You transition over five years, for example – so it will be like an observation period with some teeth," he says.

White adds that the proposals from the industry include a reduction in the amount of each transaction that cannot be netted off to 5%.

"The major recalibration is to remove or materially reduce the binding nature of the netting cap, sometimes called the net-to-gross ratio. The industry view was to put it to 5%, which would mean that most netting gets recognised. There is an argument that it still doesn't give the full flavour of how powerful multilateral netting is within a CCP. But it would at least remove one of the major mathematical or structural constraints within the CEM on recognising increased netting. During the transition period it may be seen that even further changes are needed," he says.

Prior to joining BMO last year, White was a senior regulator at Canada's Office of the Superintendent of Financial Institutions and chaired the RMG while it drew up the Basel Committee proposals on clearing house capital. At Isda's annual meeting in Chicago at the start of May, he was part of a panel discussion that touched on the rules and joked: "I'm in the unfortunate position of having to eat my own cooking."

In response to a request for comment, the Basel Committee said it is considering the proposals in light of industry feedback.