Jonathan Smith and Gerardo Ferrara
Just like the beginning of an unforeseen family argument, two key tenets of the post-crisis reforms have unexpectedly started to butt heads: the leverage ratio capital requirement and the mandatory requirement to centrally clear certain over-the-counter (OTC) derivatives.
The leverage ratio was introduced to enhance bank stability. It combats precisely one of the main drivers of the financial crisis: excessive leverage. On the other hand, mandatory clearing was introduced to address the systemic importance of derivative contracts in a push to reduce counterparty risk.
These seem unconnected, but one of the by-products of the leverage ratio is that it makes clearing derivatives on behalf of clients more expensive for dealer banks, while the mandatory requirement to centrally clear makes it essential. So, there has been a lot of argument about what this higher cost really means.
The introduction of mandatory central clearing means that many OTC derivatives can only be cleared through Central Counterparty Clearing Houses (CCPs). To do this, many institutions must go through dealer banks, as they are not able to do this directly. The question then is what if these banks start refusing some clients because it’s now just too expensive?
This is precisely what industry participants are arguing (Risk.net (2015); Risk.net (2015); The Trade (2015)). In a recent FSB report (2018, page 24) that surveyed the main incentives to provide clearing services, 72% of service providers viewed the leverage ratio as an obstacle to the provision of these services. They argue that since client clearing is already a low profit margin and competitive business, any higher cost just makes it uneconomic, potentially driving banks to cut their services, and maybe even preventing their clients from hedging risks.
But is it possible that these regulatory changes could have such an effect? Ultimately, this is an empirical question. Our recent working paper addresses precisely this issue. It examines whether the leverage ratio requirement reduces the incentives for banks to centrally clear derivatives on behalf of clients or whether this is an exaggeration. Overall, there seems to be some effect.
Why might a leverage ratio impact client clearing?
The centre of the argument surrounds the treatment of client initial margin (IM) in the leverage ratio. In a standard client cleared derivative contract, a client commissions a bank to clear the derivative via a CCP. To do so, the client must put down IM, effectively collateral, which makes the transaction safer in case it all goes wrong. The bank then passes this IM onto the CCP. The issue is that although this IM is typically held in a segregated account, it is treated as an exposure in the leverage ratio, and therefore the bank must hold capital on it. This is expensive and contrasts with treatment under the risk-based capital requirement. In this case the bank is allowed to offset the IM from its potential future exposure, and so does not need to hold as much capital on it.
This seems like a minor point, but many argue it has profound implications: an increase in costs in an already low profit-margin business could lead to a reduction in services.
So what does the data tell us?
The working paper uses extremely granular transaction and portfolio data from UK trade repositories and data collected by the Bank of England on OTC interest rate derivatives cleared at LCH (the biggest clearing house in Europe). To identify whether the leverage ratio has caused a reduction in the client cleared portion of the market, the paper exploits the phased introduction of the leverage ratio in a difference-in-difference framework.
In particular, the paper compares the behaviour of dealer banks before and after two leverage ratio events, against dealer banks that were unaffected by these events. First, the leverage ratio introduction in January 2016, which ran ahead of the Basel timeline. Second, the change in leverage ratio reporting requirements in January 2017. This is as in Kotidis and van Horen (2018) who first exploited this shock in the context of repo. The paper looks at whether there was a noticeable change in the behaviour of leverage ratio constrained versus unconstrained banks in their willingness to clear derivative transactions on behalf of their clients.
The results suggest that leverage ratio-constrained banks reduce both:
- the number of transactions they are willing to clear on behalf of their clients; and
- the number of clients they are willing to take on, particularly smaller ones.
In terms of magnitude, leverage-affected dealer banks clear on average 5% fewer transactions per client and operate with around 4-5 fewer clients than otherwise. This impact on clients is particularly driven by a reduced willingness to take on new clients: leverage-affected institutions are around 10 percentage points less likely to take on a new client.
Figure 1 shows the average number of clients serviced by clearing members three months before and after January 2017. The grey vertical line represents the 2017 change in leverage ratio reporting requirements that affected only the subset of banks represented in the blue line. The pattern seems to change after 2017, with leverage-affected dealers (blue line) significantly reducing their uptake of new clients compared to non-leverage affected dealers (red line).
Source: Acosta-Smith, Ferrara and Rodriguez-Tous (2018).
These results are consistent with the claims that increased costs borne by the leverage ratio push dealer banks to reduce their services. And this is particularly the case if the client is small and therefore less profitable for the dealer. So for instance, large hedge funds are less likely to encounter access problems than pension funds.
Where do we go from here?
New banking regulations are always criticised, but one such regulation that has had more than its fair share of criticism is the leverage ratio. So are we just adding to the misery? Well, no. Quantifying the net-benefits of the leverage ratio is beyond the scope of the paper. So while the results indicate that the leverage ratio can have an impact on client clearing in the interest rate derivatives markets, it is not possible to state whether this outweighs its benefits, which include greater resilience for banks and a reduction in model risk, and it is likely that it doesn’t.
However, if some institutions lose access to the centrally cleared market, they may find it more difficult to implement hedging and investment strategies. This reduced availability of clearing services could also raise concerns in respect to porting clients after the failure of a dealer bank. So it bears further investigation and illustrates the importance of policy evaluation. As with many regulations, it is the interaction that causes problems.
Jonathan Smith works in the Bank’s Prudential Policy Division and Gerardo Ferrara in the Bank’s Capital Markets Division.
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