Pending Impact of Global Banking Regulations

Hi, friends. Welcome back to another episode of Peer Connections, the podcast series brought to you by the Global Peer Financing Association, also known as GPFA. These podcasts offer our GPFA members and global beneficial owner friends a forum for information sharing and discussion on topics most important to them. And we hope you, our listeners, appreciate the insights, best practices, and transparency offered from our members and industry friends about securities, finance, or related investment areas. Now let's get into the episode. Hello, listeners. This GPFA podcast is brought to you by Robert Gooby, the chair of the GPFA Board of Directors, as well as Assistant Vice President for Collateral Management, Fixed Income, and Derivatives at the Healthcare Ontario Pension Plan, otherwise known as HOOP. And Rob is speaking with Thomas Aubrey. Thomas is the CEO and founder of Credit Capital Advisory, where he is a corporate business advisor and macro credit specialist. We hope you enjoy the conversation that Rob and Thomas have. And if you have any questions or other ideas for GPFA, please don't hesitate to reach out. Now over to you, Rob. Good day and welcome, Thomas Aubrey, to our Peer Connection podcast series hosted by the Global Peer Financing Association. I'm Robert Guby. I'm Head of Balance Sheet and Liquidity Management at the Healthcare of Ontario Pension Plan. And I really welcome Thomas Aubrey to this discussion. And it's really and truly looking at why does the buy-side care about banking regulations and what impact it would have on the securities finance industry. Yeah thanks Rob, great to be here and thanks for the invitation. Thanks Thomas. So the question is what concerns the buy side should have with the impact of banking regulations or maybe what impact the banking regulations have on the buy side? It's a great question and I think always one of the challenges of banking regulation is why anybody outside of banks should really care about it. Perhaps before I kind of kick off as to why the buy side should care about it. I'll probably just talk a little bit about banking regulation per se, try not to make it too dry so everyone falls asleep. But the framework for banking regulation is provided by the Basel rules with respect to capital. And now these rules are important because they determine the amount of capital banks need to have in relation to the risk they're exposed to. So in the event of unexpected losses, this capital is expected to absorb those losses to ensure the ongoing viability of the bank. So that's kind of what these banking rules are really about with regards to credit risk management. Now, these Basel rules are international, but they do kind of largely exclude the US, although there is a connection there. So why does it matter for the buy side? Well, one of the principles of the Basel regime is that capital requirements should be proportional to risk. And any counterparty that banks have, they actually have to estimate the risk of those. And obviously, those counterparties include pension funds and mutual funds. Now, up until now, banks have been using what's called an internal-based ratings approach or IRB approach to assess the risk of counterparties they're exposed to. Now, this IRB approach is based on the bank's own model and its data, and that has to be signed off by the national regulator. And this IRB approach has been generally the preference for larger banks because it's quite expensive, actually, to go down this route and to get regulatory approval. And smaller banks don't tend to have the resources to do this. So they go down what's known as a standardised approach. And for standardised capital requirements, they're largely prescribed by the regulations in relation to external ratings. So one example might be you've got an exposure to a triple B investment grade corporate, the allocation, the regulations would automatically assign a 75% risk weight. So that's the kind of nuts and bolts really of the banking regulations themselves. And of course, pension funds and mutual funds are counterparties, so they have to either be rated and therefore go through the standardised approach, or large banks can go down the IRB approach. And one of the big challenges, though, standardised banks is that many obligors they might have exposure to are unrated by what Basel calls external credit assessment institutions, or ECIs. And this means that the risk rates for the capital calculation were effectively 100% of the exposure. So when funds may wish to lend securities to the prime brokerage arm of a bank to generate income, then many of these transactions made by funds are done through large banks, which tend to use the internal ratings-based approach or IRB approach. And so the bank looks at the credit worthiness of the fund and assigns an appropriate risk weight. And the good news for an IRB bank is that most pension mutual funds are of very high quality. So the issue is most of these buy-side communities are not rated. And that is a concern, I think, from a capital perspective. What are your thoughts on that? Yeah, that really gets to the heart of the issue, particularly for standardised banks at the moment, is that less than 1% of mutual and pension funds are rated. And the reason why is it's expensive to get a rating. And also the main driver for getting a rating has always been generally to access finance or raise finance in the capital market, which isn't really that relevant to most mutual funds and pension funds. So you're right, most funds don't have a rating. So for a standardised bank, they have to give it 100% risk weight. But for IRB banks, at least up until recently, that hasn't been an issue because they've been able to model these low risk funds themselves. We see very low default rates across the pension and mutual fund sector. And so generally, we've seen kind of a rough idea is that the risk weights for these high quality funds would be around 12.5%. Now, that's very different to the 100% risk weight for standardized banks. Now, one of the challenges, and I guess this gets to the heart of the question, is after the financial crisis, the Basel rules were changed to implement what's known as Basel III. Some people in the industry call it Basel IV. And the point what the banking regulators were trying to kind of get across one of their objectives was to reduce this difference in risk rates between standardised and IRB. So where you get unrated obligors with a high quality, that's where you get these big differences. So the IRB banks can get 12.5% risk rates versus 100% risk rates for standardised. So given the objective is to kind of narrow that, what they've ruled is to say that an IRB bank's risk weights can't be lower than 72.5% of a standardised bank's risk weights. So when we look at the standardised bank's risk weights for an unrated fund is 100%. And that means the IRB bank can't really go lower than 72.5%. That's already a big jump up from 12.5%. Yeah, I guess the big issue here, you're pointing out the impact is going to be the capital charges that a bank has to transact with high quality counterparts like a mutual fund or pension plan or some other after manager is that the heart of the matter here absolutely so this is the kind of key thing why these new banking rules as well as all three rules are actually going to impact many pension and mutual funds because up until now they've been working with these large irb banks with low risk rates which means there's a lower cost of capital, so it's a lower cost of doing business. But now we're going to see a big jump in risk weights. Does it impact different geographies? Yeah, another great question. So the Basel rules are there as guidelines, but they're there to be implemented by national jurisdictions. So, so far, the Canadian regulator OSFI has actually published its view earlier this year around what we do with these unrated public doors. So I think, you know, over the last few years, I think this issue has been discussed in the marketplace. OSFI has kind of come back and said, look, we get that if these unrated funds, you end up jumping from, say, 12.5% risk weight up towards 100%, we know that's going to be an issue. So what they've come up with and said, look, if you're investment grade and you've got more than 75 million Canadian dollars in a kind of overall turnover as part of the group you're related to, that can automatically have a 65% risk weight. But if you're sub-investment grade, you'd be 150% risk weight. The European Commission last October also had a similar kind of ruling, and that may well be where sort of OSFI has followed. So the commission said that if you're investment grade as a counterparty, you'd be at 65% risk weight. Although, interestingly, the ECB doesn't like that idea at all. The UK, we're expecting to hear from them next month. So I guess that in theory, there might be a kind of opportunity for regulatory divergence. But certainly what we've seen already from the EU and from Canada is that this sort of defaults at 65% for an investment grade risk weight seems to be where the market's going. Thomas, so that was great insight on the impact of the Basel rules for Canada and Europe as a whole. But what was the impact of the Basel rules to the U.S. counterparts? The U.S. banking rules are kind of outside of Basel. I mean, there are some linkages there, but the way that the U.S. banking rules have always looked at it is that funds are basically corporates and they receive 100% risk weight across the board. Now, there is an option to bring that down to the magic 65% figure, which obviously, you know, both Canada and the EU have articulated. And that's due to whether an investment grade obligor is listed on an exchange. But clearly most funds are not. So that means they'd have a 100% risk weight. So it's kind of interesting because you can see the different costs for banks dealing with funds across the globe, dependent on the extent of banking regulations. What impact would this have on the securities finance and business, especially recognising that securities finance and business is spread very thin and you're dealing with counterparts that zero RWA charges, now it's going up to 65 or 70 or 100. What does that do for GC business? Quite hard sometimes to work out empirically what these kind of effects will have. But we've had a go. What we're trying to think through is, given this jump in the cost of capital for funds dealing with banks, what impact might that have on, as you say, securities lending, and also what impact might that have on market liquidity if we see a fall off in securities financing activity. So we've had to make a bunch of assumptions. Otherwise, we can't really get anything out. So you know, for what we've done, we've kind of assumed that banks allocate the increase in capital requirements to that business activity, and this cost is then passed on to those counterparties. So when you think about the cost of RWA for a bank, it's a little bit dry, but there's a formula which is exposure at default times the risk weight times cost of capital times the tier one capital ratio. We've got an estimate of about three basis points. I mean, it might be a little bit more or a bit less, but because obviously each bank's going to be slightly different, but that's kind of our working formula. But that's going to increase fivefold because of this jump in cost of capital from 12 and a half percent risk weight up to 65 percent risk weight so that's an extra 12 basis points of cost that's going to have to go somewhere thomas but right now the cost for gc is anywhere from 7 to 12 beats so you're saying that i gotta add that capital cost as well so gc security is going to start costing me 20 beats tomorrow or 25 beats is that what Yeah, extra 12 basis points. So from that perspective, the question is, what impact might that have on the income back to the funds? We've done some sort of simple calculations to just remove 12 basis points off that income stream. And we reckon it'll probably negatively hit that income stream by about 35%. One question it does raise, which we don't have an answer to, is given that the income for general classical trades is going to be so much lower, And I think the average is about whatever it is, 15, 17 basis points. Will people want to continue to do those trades given that the income is so low? Will people do the trade or is everything just going to be repriced in the market and financing costs is going to increase over time? Or it has to? Yeah, no, I think so. And of course, when these costs go up, where do they end up flowing to? Generally, it will end up being to savers and their retirement pots. And I think that's probably not surely not the intention of the regulators. I think this is really an unintended consequence that's come out of this. But I mean, I think there is some other analysis that particularly after or during the financial crisis, there were quite a few jurisdictions that banned short selling. So we can start to see if you do have a drop off in securities financing activity, what effect might that have on market liquidity as well? I mean, some of the studies done during the financial crisis suggested that we might see a widening of bid-ask spreads by 200 basis points. And of course, if that widens, then you've got to go up extra costs for funds trading as well. So I think that's certainly another major concern in terms of potentially negative effects on funds. And of course, on the savers are actually putting their money into both the mutual and pension funds. I think it's a very interesting issue to deal with. And time will tell, I guess, what the markets will tell exactly what impact plays off the time. Yeah, I mean, one of the challenges we've got at the moment, at least in the EU, this has been delayed in terms of its implementation until 2025. So I think that's sort of part of the challenge at the moment is that there are so many other issues the market's facing with rising interest rates and rising energy costs, etc. This may not be number one on people's radar screen at the moment. We have two years from now, basically more or less two years. What should buy-side be concerned with yet? Or maybe what advice do you have for buy-side? What are the steps we should take? Or would the rules change and just wait and see? I think it's unlikely that the regulator is going to change the rules. You know, the rules are there. They're there for a certain number of reasons. And I think this is just one of these unintended consequences. But I think in my discussions with regulators, I think they're certainly genuinely interested in working with the industry to come up with solutions to mitigate these. And I think it's important for the buy side to realise that this is a real problem and they need to work together, both with the banking community and with the regulators to ensure that there are some solutions there. And I think one sort of some of the discussions that we've been having with various buy side firms is why should we care about this? You know, so we're kind of saying, well, we think you might lose 35% of your income if you're lending securities. And some funds don't lend securities. They're saying, well, we don't really care about that. But I do think the market liquidity effects are really going to be quite significant. So we did a bit of extra analysis using a framework developed by NASDAQ, which just tries to estimate what the trading shortfall is. So that's the gap between the bid-ask spread, which in Europe is about 33 basis points. And that cost of that, that's the on-current cost, is about 7 billion euros. So if you start to widen the bid-ask spreads, and therefore you're going to get wider shortfall costs, we'd expect to see almost a tripling of those costs at least, and it may go much higher. So that 7 billion current cost, which obviously is absorbed by various parts of the sector, could end up going as high as 40 billion euros for the buyer side in terms of trading costs, if we do see bid-ask spreads widening to 200 basis points. Now, of course, we don't know that's going to happen. It's quite plausible that when these things happen, buyers and sellers start to trade less. So obviously, that means that there'll be less cost. But it's also important to note that if you're not trading, it may be that you're losing money because you're not executing trades as well. So there's an opportunity cost there. So for those interested in the empirical analysis, my paper entitled EU Capital Rules to Increase Buy-Side Trading Costs was published by Credit Benchmark and can be accessed on their website at creditbenchmark.com. One of my concerns is more on the liquidity side, the impact it has on liquidity in the market. We're seeing right now liquidity is a very topical issue and anything that impacts liquidity could be a concern going in the future. Yeah, and I think that's where we see the major concern, I have to say. I mean, as I said, with the kind of loss of income, I mean, sure, that's certainly an issue for many funds, but I think this damage on liquidity coming through, I think it's actually a systemic issue that the macro prudential regulators really do need to take stock off as well. And clearly, at this stage, we don't really know what effect might happen. I mean, if the cost of hedging goes up too much, does that mean that people will start hedging less and be taking more risk? What happens if market liquidity in sovereign bonds of certain countries dries up? They're going to have some challenges to their own fiscal position, as I said, as well as the kind of massive increase in cost for the buy side, which again, is going to be hit by savers having less money for retirement. So I think the more we've looked at it, the more we've discussed it, that issue of market liquidity is definitely the one that the buy side should be worried about now, just because of the very, very large potential effects this will have. So in our view, that's really where the buy side should be kind of rallying around, having these discussions and working out potential solutions, really. So if we were to wrap this thing up now, and what do you think? We already know that liquidity may be a problem. We got to look at the cost of capital that the bank has that impacts the buy side as well. What are the two or three things you want to leave the listeners with? And then we could have another discussion as we move forward. Yeah, so I think that although I've sort of perhaps painted a slightly bleak picture, given this very, very dramatic jump in the cost of capital for the banks and how this will change in nature and the way that banks do business with the buy side. I think there are some important points as although we don't think the regulator is going to change the rules and sales, but given the importance of the buy side to individual savers into the entire kind of financial services landscape, we certainly feel that the regulator is going to be open to this. And I think coming back to the sort of the heart of the issue, most mutual funds and pension funds are very high credit quality. And so they're in effect being penalised because of the way that the rules have ended up being developed. And I think there'll be quite a lot of sympathy to that given the role that the buy side plays. And I'm sure there are a whole series of solutions that we can come up with and discuss with regulators. And there are people working on those, but I think it might be best to wait another while before some of these solutions become potentially a little bit more solid where we can debate the pros and cons of those. But I certainly feel very optimistic that we can find a way through this challenge. We have enough time and I think there is enough openness for people to engage. Thomas, I look forward to having a chat with you on solutions. You brought up a very interesting point on the cost of capital, the impact Basel rules are going to have on the banks and ultimately flow back to the buy side. But I'm looking forward to having another discussion with with regards to what solutions are there, how are we making progress as an industry and where it ends up. And the good news is we still have over two years to solve for this on both sides. And maybe there's some interesting solutions you could think about and we'd love to talk about that more in the future. Looking forward to it, Rob. Thanks again, Thomas. Thank you. Thanks for listening to another episode of Peer Connections by GPFA. We hope you found the information shared in this podcast interesting and beneficial. And as always, please feel free to reach out to GPFA with ideas or interests for future episodes. And if you liked what you heard today, don't forget to subscribe wherever you get your podcasts. Now for the disclaimer. The opinions expressed in this podcast are those of the presenters and do not necessarily reflect the views or opinions of their respective employer organizations. This material is for your private information and does not constitute legal, tax, or investment advice. There's no representation or warranty as to the current accuracy of nor liability for decisions based on this information.