Federal Reserve Board of Governors
Friday, October 30, 2015
Key Topics & Takeaways
- Unanimous Approval: The Fed Board voted to unanimously approve 1) Proposed Rule on TLAC and the buffer on long-term debt; 2) Final Rule – Margin and Capital Requirements for Covered Swap Entities; 3) Interim Final Rule and Request for Comment – To exempts from the Agencies’ swap margin rules non-cleared swaps and non-cleared security-based swaps in which a counterparty qualifies for an exemption or exception from clearing under the Dodd-Frank Act; and 4) Delegation of Authority to the Director of Banking and Supervision to Approve Margin Models.
- Quantum of Capital under TLAC Regime: Booker explained that, when fully phased in, the minimum TLAC requirement would be at least 18% of RWA or 9% of a firm’s leverage exposures, saying the TLAC proposal takes into account a firm’s specific risk profile and systemic footprint.
- Deposit-Funded Banks: The proposed TLAC requirement would require firms to take on debt even when they have a large deposit base, which Fed staff explained is not intended to favor any particular business model, however a loss absorbency regime needs to be “thought about differently.” Van Der Weide explained banks that are predominantly deposit-funded will need to raise additional debt, since deposits tend to be demand or short term, rank equal or senior to other liabilities of firms (i.e. don’t have contractual or structural subordination for loss absorbency), and depositors are “not good loss absorbers” in a crisis.
- Benefits of Margin: Fed staff noted the final rule on margin for uncleared swaps would: 1) reduce the risks associated with uncleared transactions; 2) reduce the “scope for contagion dynamics;” and 3) provide an incentive to move transactions to central clearing.
- European Treatment of Inter-Affiliate Transactions: Fischer asked why foreign jurisdictions are not imposing initial margin requirements on inter-affiliate transactions. Campbell said that the statutory requirements that govern the European Market Infrastructure Regulation (EMIR) restrict imposing this requirement.
In her remarks, Chair Yellen briefly summarized the importance of the policy proposals under consideration, total loss absorbing capacity (TLAC) and margin requirements for uncleared swaps, in implementing the post-crisis financial reform agenda. Yellen claimed that the “core of the [TLAC] proposal would require that banking firms maintain at all times a minimum amount of long-term debt that could be converted into equity in resolution.” This, she said, combined with other efforts to improve resolvability of systemic banks, would “substantially reduce the risk to taxpayers and the threat to financial stability stemming from the failure of these firms.”
Tarullo claimed that the TLAC proposal was a key component of the post-crisis financial reform agenda and necessary to address the ‘too big to fail’ (TBTF) problem. Tarullo noted that capital and liquidity requirements, as well as annual stress tests, have increased the resilience of systemically important financial institutions (SIFIs), and he argued that the introduction of TLAC would help ensure that SIFIs can fail without “causing disorder in financial markets or requiring injections of government capital.”
Tarullo provided a brief overview of the proposed TLAC requirement, stating it would increase loss absorbing capacity of global systemically important banks (GSIBs) by requiring parent holding companies of U.S. GSIBs to maintain outstanding long-term debt that is structurally subordinated to other liabilities. He explained that TLAC would also apply to foreign GSIBs with intermediate holding companies in the U.S. Tarullo then claimed that firms may use equity buffers in excess of the minimum capital requirements to help satisfy the TLAC requirement.
Staff Presentation – Total Loss-Absorbing Capacity
Felton Booker, Senior Supervisory Financial Analyst
Booker explained that the “primary goal [of the TLAC proposal] is to ensure the U.S. GSIBs have sufficient capacity to absorb losses without taxpayer support.” In effect, he said, TLAC would require G-SIBs and their investors to “prefund orderly resolution.” Booker claimed that a core element of the proposal is to require the parent holding companies of the eight U.S. G-SIBs to hold external long-term debt, which he said would amount to six percent of a firm’s total risk-weighted assets plus the applicable G-SIB surcharge, or four percent of the Supplementary Leverage Ratio. In this way, he argued, the TLAC proposal takes into account a firm’s specific risk profile and systemic footprint. Booker explained that, when fully phased in, the minimum TLAC requirement would be at least 18 percent of RWA or nine percent of a firm’s leverage exposures.
Booker also explained that the location and quality of long-term debt is important to be effective as a loss-absorbing instrument. As such, the proposal would require external long-term debt to be issued at the parent level to ensure it can absorb firm-wide losses. Booker also clarified that structured notes “would not count as external long-term debt.”
Booker claimed that the staff proposal was based on analyses conducted based on historical loss analysis throughout financial crises. He assured the Board that the proposed calibration of minimum TLAC was sufficient to ensure the presence of enough capital to absorb losses as well as recapitalize a bank back to a going concern level. He also estimated that the shortfall for U.S. GSIBs in aggregate to meet the minimum amount of the long-term debt requirement would be $680 billion, and that six of eight of those institutions have an aggregate shortfall of $120 billion. Importantly, he also noted that any U.S. GSIB that already meets existing capital requirements and buffers would be able to fill the shortfall solely by issuing additional long-term debt, and he estimated that the aggregate shortfall ranged from $680 million to $1.5 billion. He closed by claiming that the estimated benefits would outweigh the costs of this proposal and argued that the proposed rule would result in “substantial benefits to the U.S. economy.”
Mark Savignac, Senior Financial Analyst
Savignac explained that the internal TLAC requirement, which he claimed generally parallels the external TLAC requirements, would apply to intermediate holding companies of foreign GSIBs. However, he explained that internal long-term debt (which transfers losses within a firm) serves a slightly different purpose than external debt (which passes losses out of a firm to investors). The internal debt requirement, he claimed, would help mitigate risk to financial stability posed by the failure of a foreign GSIB with a large U.S. presence. He also claimed that internal debt requirements would help contribute to foreign resolution actions through the single point-of-entry regime (SPOE). Savignac outlined several additional components of the internal TLAC requirement, such as the requirement that a board may cancel debt or convert it to TLAC if it deemed appropriate, as well as a “clean holding company” component, which he claimed would mitigate the risk of cross-defaults.
Savignac explained that the proposed effective date of this rule is January 1, 2019, with the RWA component being phased in by January 1, 2022. The proposed rule will be open for public comment through February 1, 2016.
Question and Answer
Debt vs. Equity
Yellen asked why the proposed rule favors debt over equity, which many believe is superior in terms of absorbing losses. Staff affirmed that the proposal calls for minimum amounts of unsecured long-term debt in addition to a minimum level of TLAC. They claimed that equity “may not be the perfect substitute” for long-term debt and noted that, in past bank failures, equity of most large banking institutions was “fully depleted” post failure. Thus, they concluded, equity is “far less reliable” to recapitalize a banking institution post failure. Instead, they argued that the long-term debt requirement would ensure that, at the point of failure, there would be a known observable quantity of loss-absorbing capacity.
Yellen also asked about staff’s thinking on pre-positioning debt within a holding company structure. Savignac explained that pre-positioning would help ensure appropriate distribution of loss absorbing capacity, however he noted that the proposal does not include an internal TLAC requirement. The staff hopes to receive feedback via the public comment period on this issue.
Fischer asked whether the requirement to hold more capital would decrease lending capacity of GSIBs. Mark Van Der Weide, Deputy Director, Division of Banking Supervision and Regulation, explained that the staff conducted a quantitative analysis on the impact of funding costs and lending spreads, and claimed that it showed the requirement would be relatively inexpensive for firms to meet. For instance, he claimed that GSIBs could reshuffle capital held at subsidiaries and move it up to the parent level or refinance debt out longer term. Van Der Weide claimed he did not think the cost of compliance will be great and argued that the financial stability benefits “will be large.”
American Subsidiaries of Foreign GSIBs
Fischer asked about the long-term debt requirement on American subsidiaries of foreign GSIBs, which the staff explained they expected foreign jurisdictions to implement this same requirement (on material U.S. offshore subsidiaries).
Tarullo asked whether it was “fair to say” that the shortfall estimates are mainly limited to the need for restricting the term and duration of debt and the location where it is held. Booker responded that there is “low hanging fruit” for firms to meet this requirement, largely at the discretion of how firms decide to comply. He argued that some firms will have the ability to move debt up to the parent company level “quite cheaply” and that other firms may pursue a different approach.
Tarullo also asked why the proposed rule would possibly require firms to take on debt even when they have a large deposit base. Van der Weide explained that the proposal does not aim to favor any particular business model. He claimed that deposits get “significant credit” in the Fed’s liquidity ratios, however for a loss absorbency regime it needs to be “thought about differently.” Van der Weide explained that the proposal provides additional protection for deposits, which tend to be dmand or short term, rank equal or senior to other liabilities of firms (i.e. don’t have contractual or structural subordination for loss absorbency), and that depositors are “not good loss absorbers” in a crisis.
Long Term Debt Requirement
Jerome Powell asked why the long-term debt requirement is also necessary. Booker explained that both provide loss absorbing capacity, but the minimum long-term debt requirement would be more reliable and constitute a “final firewall” for post failure re-capitalization.
The Fed Board voted to unanimously approve the motion to publish for comment the Proposed Rule on TLAC and the buffer on long-term debt, as well as the motion to authorize staff to make technical and minor changes to prepare the documents for the Federal Register notice.
Staff Presentation – Margin and Capital Requirements for Covered Swap Entities
Van Der Weide began by explaining that the rule provides three main benefits: 1) margin will reduce the risks associated with uncleared transactions because collateral will be available to settle losses for these non-standardized products; 2) a regulatory regime where all market participants know margin will be available will reduce the “scope for contagion dynamics;” and 3) market participants will have an incentive to move their activities to central clearing.
Sean Campbell, Division of Banking Supervision and Regulation, noted that the Fed consulted with the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) when creating the rules and that the final draft was changed based on comments received during the rule’s proposal stage. He noted the Fed’s rule applies to entities that are “primarily banks” and it adopts a risk based approach that is consist with statutory requirements to ensure safety and soundness of the banking system. He added that the rule’s risk-based approach distinguishes between the different types of counterparties in setting margin requirements: 1) swap entities; 2) financial end-users; and 3) other counterparties such as multi-lateral development banks and sovereign funds.
Campbell explained that the amount of initial margin required would be calculated using either a “simple, standardized table” or entity’s internal model, subject to approval and oversight by regulators. He said the “significant change to market practice” that would result from the rules reduces systemic risk, but “comes at a cost,” noting that the posting and collecting of margin will require a “significant amount” of high quality liquid assets that will not be able to be used elsewhere. He said the long run cost will be an estimated $315 billion for non-cleared transactions between counterparties and highlighted that asset management and insurance companies will have lower costs associated with raising collateral. He added that the cost of raising collateral will be about $2.5 billion a year.
Campbell said the impact of variation margin requirements is “likely to be low” because exchange of variation margin is currently a best practice.
He also highlighted that if a counterparty is not a swap entity or an end user, then the rules only require initial and variation margin to be collected “as deemed necessary” in accordance with a firm’s risk management policies and procedures. He then added that small banks ($10 billion or less in total assets) and non-financial end-users who use derivatives for hedging are exempted.
Anna Harrington, Counsel in the Federal Reserve’s Legal Division, explained that a “broad array” of collateral is eligible for initial margin including government and corporate bonds, and that this collateral is subject to risk-based haircuts, to withstand fluctuations in assets values. She said the broad scope of eligible collateral would “alleviate liquidity cost.”
Harrington said that variation margin will require cash for transactions between two swap entities but that all of the types of collateral eligible for initial margin will be allowed for variation margin for transactions with financial end-users. She noted that this is a change from the proposed rule made to address comments from financial end-users who said that holding cash as collateral would “drag” on investment portfolio returns.
She explained that the rules require swap entities to arrange for segregation of collateral posted at third party custodians and that the custodial agreements must prohibit rehypothecation.
Harrington then mentioned that the final rule was intended to limit the extraterritorial reach of U.S. regulators to “maintain competitive equity,” by allowing for substituted compliance in jurisdictions whose regulations are determined to be comparable.
Harrington noted that there are special rules for initial margin for transactions between a swap entity and an affiliate. She said that under the proposed rule, the requirements for inter-affiliate transactions would have been the same as those for transactions with a third party. However, she highlighted that commenters noted the importance of these transactions for risk management purposes and that commenters expressed concern that the proposal would create a disincentive for these practices.
She said that transactions with an affiliate poses a risk to the swap entity, which is normally a depository institution, and thus the final rule requires the collection of margin on a daily basis. However, she said that the rule, unlike the proposal, would not require swap entities to post initial margin to affiliates, but rather requires a swap entity to calculate and report how much initial margin would have been posted.
Harrington noted that a significant amount of collateral would be required for inter-affiliate transactions and that these requirements represent a significant change to market practice. She highlighted that market participants will be required to make operational and legal changes and thus it is important to provide firms with sufficient time to conform to the rules. She explained that the rules will be phased in over four years, beginning in 2016, and that the largest entities will be required to comply first, with smaller firms “following over the next several years.”
Question and Answer
Incentives for Clearing
Yellen asked how strong the incentives are to encourage centralized clearing. Campbell said incentives vary by each swap but that, generally, margin on uncleared swaps will be 30-40 percent higher than cleared swaps. He added that the aim of the rule was to put cleared and uncleared swaps on “an equal footing” from a risk perspective.
Internal Models for Initial Margin
Yellen then asked how comfortable the staff is with relying on internal models to assess the magnitude of initial margin. Campbell said that while the staff’s view on “the wisdom of internal models” has changed in the past five years, they are comfortable with permitting internal models subject to oversight and approval, noting that these are complex transactions and a creating a standard model is a challenging task. He added that the rule has a section on the standards required for models to gain approval. He added that staff will conduct back testing and will be focused on the “verify” portion of its “trust and verify” approach.
European Inter-Affiliate Differences
Fischer asked why foreign jurisdictions are not imposing initial margin requirements on inter-affiliate transactions. Campbell said that the statutory requirements that govern the European Market Infrastructure Regulation (EMIR) restrict imposing this requirement.
Fischer asked if swap transactions will cost more as a result of the rules. Campbell noted that they will cost more than in the past and that levying initial margin on transactions between swap dealers is “an enormous change” in the market. He said that the $315 billion cost figure cited earlier is largely driven by the costs stemming from large swap dealers putting up initial margin.
Fischer said the volume of swaps transactions is “astronomical” and asked if the rules will reduce this volume. Campbell said that “at the margins” there will be cases were additional requirements will make transactions too costly, but said to the extent that swaps are “dealing with real risk,” the staff does not think margin requirements will “get in the way” or provide incentives to move away from good risk management practices.
Tarullo said that Section 25(a) of the Federal Reserve Act and Regulation W require insured depository institutions to be insulated from other parts of a bank holding company and asked if Dodd-Frank address this. Scott Alvarez, Federal Reserve General Counsel, said that Dodd-Frank does address this issue and that there had been some doubts about derivatives in the context of Section 25(a). He said the staff considered this at length when creating the margin rules and that “both pull in the same direction.”
Netting Current Swaps
Powell asked how the rules affect swaps that are currently outstanding for the purposes of netting. Harrington explained that the rules do not apply to swaps entered into before the compliance date, but that the rules allow for counterparties to consider previous swaps for purposes of netting, if they wish to apply the new requirements to them. Campbell added that it is “dealer’s choice” and that previous swaps are allowed but not required to be put in the “new bucket” of requirements.
Powell asked how the rules affect commercial end-users. Harrington said that Congress exempted commercial end-users from the rule requirements through a provision in the Terrorism Risk Insurance Program Reauthorization Act of 2015 (H.R. 26).
The Federal Reserve Board voted unanimously to approve: 1) Final Rule – Margin and Capital Requirements for Covered Swap Entities; 2) Interim Final Rule and Request for Comment – To exempts from the Agencies’ swap margin rules non-cleared swaps and non-cleared security-based swaps in which a counterparty qualifies for an exemption or exception from clearing under the Dodd-Frank Act; and 3) Delegation of Authority to the Director of Banking and Supervision to Approve Margin Models.
More information about this proposal can be accessed here.
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