RBI released consultative document for the uncleared margin requirement

The Reserve Bank of India released a discussion paper on margining un-cleared OTC business, in the same framework as others. The RBI intend to mandate the schedule based approach to IM, unless they give approval for a VaR based approach. 

Will there be any benefit for Banks to create highly expensive infrastructure for IMM models

BCBS has recently released consultative document, Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches. It proposed that banks be barred from using internal models when they calculate how risky certain assets are. Lending to other financial institutions and large companies, and holding equities are the areas most affected.

The proposed changes to the IRB approaches set out in this consultative document include a number of complementary measures that aim to:
1.  Reduce the complexity of the regulatory framework and improve comparability
2. Address excessive variability in the capital requirements for credit risk.

Specifically, the Basel Committee proposes to:

• Remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes 
• Adopt exposure-level, model-parameter floors to ensure a minimum level of conservatism for portfolios where the IRB approaches remain available 
• Provide greater specification of parameter estimation practices to reduce variability in risk weighted assets (RWA) for portfolios where the IRB approaches remain available.

Under the proposal, banks will have to use a standardised method of calculating the riskiness of loans to financial institutions and to large corporates with assets of more than €50bn. The Basel group believes there is so much publicly available information on the credit risk of such institutions, that banks are rarely able to provide a better estimate than an approach standardised by regulators.

These proposed regulation are already dubbed as BASEL IV by street. Banks have already spent billions of dollars to comply with the plethora of regulatory changes after the 2008 financial crisis.
Argument is if banks will not be able to use the IMM models for most of the derivative portfolio, as most of the derivative trades happens among financial firms, then how much benefit will banks have in developing highly complex IMM models.

Good series to read on Market Liquidity

Introduction to a Series on Market Liquidity.

Bail In - Total loss-absorbing capital (TLAC)

In November 2014, Financial Stability Board proposed a minimum total loss absorbing capacity requirement ,TLAC,to make sure that world's 30 most systemically important banks (G-Sibs), BCBS defined these banks as Too big to fails, can be stabilised and shut down in orderly way with out taxpayer bailouts. The TLAC rule would require banks to issue ordinary shares, subordinated debt and other potentially loss-absorbing securities equivalent to as much as 15-20% of their assets weights for risks. 

Basel III rules require banks to meet a minimum total capital ratio of 10.5% by 2019 – though in some jurisdictions the minimum ratio is far higher. The proposed minimum TLAC requirements for G-Sibs unveiled at the G20 Brisbane summit in November 2014 is 16% to 20% of a group's consolidated risk-weighted assets. This proposal was under consultation until February 2, 2015, when the requirement was finalised.The TLAC rule is set to take effect in 2019 at the earliest.

This the concept of 'bail in' spearheaded during the Lehman's collapse. Wilson Ervin, now credit suisse's vice chairman, explains how his Lehman experience led to the creation of bail-in, and describes some of the innovations by the Swiss regulators.

Initially FSB excluded all structured notes/securities from the TALT requirement,  now structured notes are being considered to the extent that the repayment of the principal at maturity is unconditional and not contingent on any derivative-linked feature, reported by Bloomberg. 

COCO bonds raised by many banks can be considered as bail-in type securities. Regulators needs to increase the oversight on COCO bonds as risk profile of these bonds are complex as suggested by FT.

Swiss regulators pushed for 5% leverage ratio for TBTF banks

• As per Bloomberg, Swiss regulators will require that country's biggest banks to have capital of 5% of total assets - this will be in line with the rule for U.S. too-big-to-fail lenders, and significantly above the 3% minimum set by Basel.

• UBS and Credit Suisse have argued the Swiss financial system isn't comparable to the U.S. with its far deeper capital markets.

• Leverage ratios have gained favor among regulators as the most effective way to evaluate a bank’s robustness because the method doesn’t involve estimates of risks on their activities.

• Switzerland imposed some the world’s strictest too-big-to-fail requirements in 2011 after the government came to UBS’s rescue during the 2008 financial crisis. UBS and Credit Suisse have assets of 1.83 trillion francs combined, about three times the size of the Swiss gross domestic product, making the two banking behemoths a disproportionately bigger danger to their country’s economy if they fail than their peers elsewhere. Both are compliant with all Swiss capital rules.

Battle lines are drawn, among CCPs, who will win rates

A good read on this.

Growth of shadow banking

A good read on Growth of shadow banking from IMF blog.

Contingent convertible capital instruments (CoCos)

CoCo, Contingent convertible capital instruments are the hybrid debt instruments that absorb the losses of the issuing bank when the capital of the bank falls below certain level. These instruments have come into existence since 2009, after the financial crisis.

Though banks have issues closed to $70 bn worth of CoCos, still a lot less than issued subordinate or senior unsecured debt in same time period.

The main features of CoCo instruments are how they absorb losses and what are the triggers for them.CoCo absorb losses either by getting converted into equity or by write downs. Triggers can be based on mechanical rules or these can be supervisors’ discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values.

Discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors’ judgment about the issuing bank’s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank’s insolvency.
As per BCBS guidelines, CoCo can be part of the tier 1 capital if minimum trigger level for the instrument is 5.125%. Lower triggered CoCos can be part of the tier 2 capital.

As discussed in FT, CoCo instruments are highly complex and they can behave as death spiral risk (losses accelerates as things gets worse). In normal markets these instruments behave as HY bond but in distress markets they expose investors to equity like risk and volatility. Currently Both banks and regulators are smiling at the success of bail-in bonds. For regulators, cocos help to plug the capital gap of European banks. For bankers preparing for the upcoming European Central Bank stress tests, cocos are a cheap way to boost capital: they cost roughly half the return on equity demanded by shareholders, and interest is tax-deductible. It seems like a win-win.

The yields on CoCos are consistent with their place in the bank’s capital structure. CoCos are subordinated to other debt instruments as they incur losses first. Accordingly, the average CoCo yield to maturity (YTM) at issuance tends to be greater than that of other debt instruments (eg other subordinated debt and senior unsecured debt). The YTM of newly issued CoCos is on average 2.8% higher than that of non-CoCo subordinated debt and 4.7% higher than that of senior unsecured debt of the same issuer.

The capital adequacy of banks - today's issues and what we have learned from the past

A good read on Capital adequacy of Banks by Andrew Bailey.

There are a number of reasons, which cover both the numerator and denominator of the capital ratio. In brief: the definition of capital set in Basel I included instruments that did not properly absorb losses; capital requirements were too low in relation to the underlying riskiness of assets, particularly for the trading book; and banks were able to move risk assets increasingly into the trading book. The finger is often pointed at Basel II for enabling all of this to happen, but the timeline suggests that the problems built up under the combined Basel I and Market Risk Amendment regime

Basel I allowed hybrid debt instruments to count as Tier 1 capital even though they had no principal loss absorbency mechanism on a going concern basis. They only absorbed losses after reserves (equity) were exhausted or in insolvency. It was possible to operate with no more than two per cent of risk-weighted assets in the form of equity. The fundamental problem with this arrangement was that these hybrid debt instruments often only absorbed losses when the bank entered either a formal resolution or insolvency process. It was more often the latter in many countries, including the UK, since there was no special resolution regime for banks (unlike today). But the insolvency procedure could not in fact be used because the essence of too big or important to fail was that large banks could not enter insolvency as the consequences were too damaging for customers, financial systems and economies more broadly.

The big lesson from this history is that a going concern capital instrument must unambiguously be able to absorb losses when the bank is a going concern.

On the form and use of capital instruments, the Basel I Accord also allowed hybrid debt capital instruments to support the required deductions from the capital calculation, such as goodwill, expected losses (introduced later under Basel II with the internal models regime for credit risk) and investments in other banks' capital instruments. However, as a matter of fact, rather than reporting, any losses arising from these items hit common equity because it will absorb losses first in the going concern state, according to the hierarchy of the capital structure. As a result applying these deductions at the level of total capital, or Tier 1 capital, has the effect of overstating the core equity capital ratio.

The Market Risk Amendment and Basel II dramatically increased the complexity of the capital framework, and whilst it intended to increase the scope of risk capture in the regulatory capital measure it ended up creating new opportunities for "optimising" regulatory capital. Even more difficult, the potential benefits - better differentiation and rank ordering of risk - were undermined by the problems of calibrating overall capital standards, and poor implementation in the rush to achieve compliance. Under Basel I and II, capital ratios were too low to sustain confidence in banks, and thus the system as a whole, through a severe stress, as the crisis sadly demonstrated. The minimum Tier I ratio was 4% of Risk Weighted Assets. And, crucially as the Tier I ratio included capital instruments with the flaws I described earlier, the core (equity) ratio could be as low as 2%. In the trading book, under the Market Risk Amendment, capital requirements could be less than 1% of trading book assets