EU Parliament creates multiverse of SA-CCR outcomes

Some MEPs want to ease rules further than EC draft; others want return to undiluted Basel text

European Parliament

The final European Union approach to a key piece of bank capital regulation governing the treatment of derivatives trades has become highly uncertain, after members of the European Parliament tabled a range of contradictory amendments for debate.

The rule, known as the standardised approach to counterparty credit risk (SA-CCR), is part of a package of measures proposed by the European Commission in October 2021 to implement the final Basel III framework agreed by the Basel Committee on Banking Supervision in December 2017. Other elements of the proposal include an output floor on all internal models used to calculate capital requirements.

The EC suggested easing the SA-CCR compared with the Basel approach. While some MEPs want to loosen the rule still further, others have proposed reverting to the original Basel text instead.

“We have a mixed bag,” says Sahir Akbar, a managing director in prudential regulation at the Association for Financial Markets in Europe (Afme). “There is the possibility of going further, but it’s not absolutely certain, we’ll have to wait and see how that turns out.”

The Basel SA-CCR, designed to capitalise the risk of default by a bank’s derivatives counterparty, includes a multiplier of 1.4x, known as the alpha factor. The EC proposed lowering the alpha factor to 1x when using the SA-CCR to calculate the output floor. That would make the floor less likely to become a binding constraint, by reducing the gap in risk-weighted assets between the standardised approach and the internal models method (IMM) for counterparty credit risk.

Multi-use ratio

Both the European Parliament and Council of the EU are debating the EC’s October 2021 proposals, known as the third Capital Requirements Regulation. The previous iteration of the rules – CRR II – introduced the SA-CCR with Basel’s 1.4x multiplier, and has been in force since mid-2021. This prompted alarm from EU banks, because the US had unilaterally decided to lower the alpha factor to 1x for derivatives exposures to corporate counterparties. The US version became mandatory in January 2022.

SA-CCR has also proved controversial because individual banks have suffered headline-grabbing uplifts in capital requirements depending on the composition of their derivatives books. Short-dated foreign exchange derivatives have been a particular victim.

Research by trade analytics provider BestX has placed the difference between US and European bid/offer spreads at 0.2 basis points since the regulation came into force at start of this year. While European banks are said to have taken advantage of this, the impact may be temporary as costs get passed down.

Although it is in theory optional for banks to use SA-CCR in calculating risk-based capital requirements, some banks cannot justify the expense of running internal models for all portfolios and trades, due to the complexity of more exotic products. IMM requires trades to be revalued thousands of times, according to a senior quantitative analyst at a European bank.

“That constitutes a performance problem, because it takes a long time and you need fast models,” says the analyst. “In theory, you could do that for all trades, but… how many resources do you want to put in, to be able to maintain this for a small number of complex trades versus the [capital] benefit you get?”

You don’t want certain member states applying and some not, it’s a matter of EU consistency and a level playing field
Sahir Akbar, Afme

And capital held against derivatives counterparty risk is not the only route through which SA-CCR will affect overall prudential requirements. SA-CCR is also used in other elements of the capital framework, including the leverage ratio exposure measure and the limit on large exposures to a single counterparty.

CRR III includes the Basel output floor, which dictates internal models used by banks cannot result in aggregate risk-weighted assets (RWAs) lower than 72.5% of those produced by standardised measures. Expressing that calculation in reverse, the output floor begins to bite if standardised RWAs are more than 37.9% higher than internal model outputs. The tougher the final version of SA-CCR in CRR III, the more likely it is that the output floor will become the binding constraint for dealers with large derivatives books.

Following a suggested parliamentary draft of CRR III by rapporteur Jonas Fernandez, all the proposed amendments to the text by MEPs who sit on the economic and monetary affairs committee were published in August.

In total, 12 of the committee members want to ease the draft further than the EC proposal. Of those, six want to ensure that the lower alpha factor is retained permanently for the output floor. The original draft suggests this change as transitional relief that will expire in December 2029, with the option for the EC to extend it or make it permanent through a delegated act – also known as level two legislation.

An additional amendment, supported by eight of the 12, would set the alpha factor to one for exposures to corporates when using SA-CCR in all other parts of the capital framework, not just the output floor. That would align the EU with the US approach.

But not all the amendments lowering the alpha factor would automatically apply to every bank. Othmar Karas, an MEP for the largest party – the European People’s Party – who is seeking to ease the SA-CCR, would make this conditional on permission from individual competent authorities.

“It is positive, but may mean that not everyone can apply it consistently – that’s not the ideal solution,” says Akbar of Afme. “You don’t want certain member states applying and some not, it’s a matter of EU consistency and a level playing field.”

The SA-CCRosanct text

A significant number of MEPs still want to remain aligned with the Basel Committee’s original version of the rules. These 10 MEPs have proposed deleting the EC’s transitional relief, resetting the alpha factor to 1.4x in the output floor.

“For banks, where the output floor is binding in the transitional period, it is obviously a big problem if the regulatory capital increases by 40% for counterparty credit risk compared to the Commission’s suggestion,” says a senior market and counterparty credit risk modeller at a European bank. “And the option that the alpha becomes 1 permanently via level two legislation also disappears.”

The senior modeller finds SA-CCR with a 1.4 alpha factor leads to double the amount of RWAs for counterparty credit risk compared with IMM, although that divergence will vary bank-by-bank.

An opinion by the European Central Bank published on March 24 this year urged lawmakers to reject the lowering of the factor as it “would leave some prudential risks uncovered and would underestimate the exposure amount for counterparty credit risk.” The MEPs also point out that the 1.4x alpha factor is consistent with the multiplier used in the IMM to address model risk.

Banks dispute the need for the same multiplier to be applied to internal model and standardised approaches, because standardised methods do not contain the same model risk and are intended to be conservative by design. Sources think the 1.4x alpha factor is particularly perverse when applied to SA-CCR’s measure of current exposure, although it might be more appropriate to apply a multiplier of more than 1 to the measure of potential future exposure in the same rule.

“We know what the current exposure is, there’s no uncertainty about that,” says the senior quantitative analyst at the European bank. “What the models are doing is that they try to estimate the distributions of the future exposure, and that’s where you apply a lot of different assumptions.”

What’s next?

MEPs will now have to find a compromise between two very different attitudes to the EC’s proposed softening of SA-CCR. The Council of the EU, comprising representatives from national governments, will also draft its own text.

Once the Parliament and Council have formulated negotiating positions, a trialogue process with the EC will take place to agree the final legislative text.

Given the balance of opinion among MEPs, Afme’s Akbar believes there is more chance of the framework being relaxed from the EC’s original proposal, rather than reverting back to the Basel Committee’s original setting.

“I don’t see that [return to the Basel text] as a likely outcome because most of the European Parliament is supportive of at least going further, with a significant minority seeing it tightening,” says Akbar. “Within the Council, there is some opposition to transitional relief, but on balance it appears as though there is support for the Commission’s proposals.”

Unless the EU lowers the alpha factor in all uses of the SA-CCR for exposures to corporates, it could put European banks at a disadvantage to competitors based in the US. But US regulators have yet to publish their approach to the rest of Basel III, and there are industry fears this could involve jettisoning the IMM altogether. That would make the EU approach – allowing internal models, but with the 72.5% output floor – less punitive overall, even if the 1.4x multiplier is applied.

Gregg Jones, a senior director in the International Swaps and Derivatives Association’s risk and capital division, says the ongoing debate “highlights to us that there is a need for Basel to review the SA-CCR framework from an international perspective to avoid any potential fragmentation”.

The Basel Committee did not provide comment for this story.

Editing by Philip Alexander

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