Sunday, February 12, 2017
Author: David Schwartz J.D. CPA
To look for the effect of new rules on banks, regulators rely on academic models that treat banks as aggregates. In truth, global banks are collections of service businesses, not simply larger versions of George Bailey’s 1946 community lender. Missing that fact may be one reason why the list of unintended consequences from regulatory reform is growing. Critics in the U.S., without anticipating a challenge, are calling for the repeal of the Dodd-Frank Act. But expecting repeal is a dangerous strategy for bankers.
There is much that can be accepted as good in the regulatory reforms. Even the more challenging rules have resulted in innovations that improve the banks’ business models. Pressed by their capital ratios, resourceful bankers have reacted by improving their ability to interact with customers. Still, those businesses might not be able to justify their cost of capital. Only time will tell.
As the review process gets underway, one legislative challenge will be to save the good while rejecting the bad. Toward that end, it’s expected that the Financial CHOICE Act will soon be proposed in Congress, opening the next phase of the eight-year, post-crisis debate on Financial Regulatory Reform.
WHAT’S GOOD FOR BANKS IN GENERAL MAY NOT BE SO GOOD FOR MARKETS
Each business within a global bank must clear a hurdle rate of return on equity (ROE). In the United States, regulatory reforms are adding capital requirements that force senior bankers to pick and choose among their business lines based on ROE. The losers are shut down and the staff reassigned or released.
Bankers provide many low margin services as accommodations for customers. They do this to cement the business relationship. Under the new rules, there’s not enough return on certain services to justify the capital required, even though the overall customer relationship may be quite profitable. Many bankers are in a quandary, believing that their banks can’t be competitive without a full range of services. But regulations are making that very difficult.
Securities services for institutional investors can be used to illustrate the point. These information technology (IT) services help stabilize markets and facilitate trading liquidity that adds depth to pricing. One service line that has been damaged by the Dodd-Frank regulations is that of agency securities lending for institutional investors.
Agent banks offer securities lending services as a way of generating extra portfolio income for themselves and their institutional customers. Securities lending helps protect the pension income for thousands of teachers, plumbers, and other retirees. For the borrowers, securities lending makes possible the arbitrage strategies of traders. Relationships with banks’ agent lending divisions improve the borrowing broker-dealers' access to collateral and credit, among other benefits. Ultimately, market prices are kept in balance, lowering risks for all investors. All good, except that the Dodd-Frank-empowered regulations threaten to shut down those service lines that don’t generate enough income to justify their capital charges.
Since the passage of Dodd-Frank in 2010, the collective resources of banks have been devoted to coping with new rules. Many of these have been formulated by the Basel Committee and the Financial Stability Board. Yet, even as banking has moved ahead to comply, evidence is mounting that at least some of the new rules are harming, more so than helping the economy.
Industry studies have computed a reduction in liquidity in the short-term funding markets and attributed that to the effects of the net stable funding ratio, the liquidity coverage ratio, the leverage ratios and/or the Volcker Rule. Even regulators have acknowledged these unintended consequences. Meanwhile, politicians have lamented that U.S. banks are not lending the vast funds being injected into them by the Fed’s quantitative easing program.
New capital requirements are threatening the economics of indemnification that agents offer institutional lenders against borrower default. The new capital rules eliminate the default indemnification. It’s far too expensive for banks to reserve capital against the risk, per the new rules, even when the loan is over-collateralized. So banks won’t offer the protection. And, without it, many lenders must withdraw their portfolios from the lendable pool.
In part, that’s because some lenders are required by local law to lend only with indemnification. Beyond that, the income from lending may not be seen as sufficient for lenders to devote the level of management attention that would be needed to justify the extra costs of lending. That’s one challenge for banks: offer services that support the due diligence duties of lenders and, at the same time, make it easier for borrowers to manage their own risks.
Borrowers bear an exposure to their lenders because of the loan’s over-collateralization. They deposit collateral as much as 5% over the value of the trade. Usually, that’s provided in cash or high-quality liquid assets. The risk weighting of the exposure to the lender varies with, among other factors, the credit rating of the lender. Since risk-weighted capital charges would be higher, the borrowers prefer not to deal with “risky” lenders. (That said, if the lendable quality of the securities that the fund commits is appealing enough, then borrowers will usually find a way to manage the costs.)
Pension funds known to be without enough assets to meet future obligations – and there are many -- will have to explain to prospective borrowers why a relationship would be worthwhile. To the borrower, there would have to be enough profit to justify the cost of extra capital needed to be held against the risk of that fund’s inability to refund the over-collateralization in a crisis. It will be a hard sell for the fund’s managers – and its agents.
HOW RELATIONSHIPS ARE CHANGING TO COPE WITH THE NEW RULES
Given the growing negative publicity about regulatory reforms, one might ask, have there had been any benefits? Or, is it all just misdirected interference with the market, as some critics allege?
That’s a big question. The effect of the new rules is hugely important to professionals in the securities finance business. Their careers depend on building profits, in part, by adapting their services to changes in their marketplace. Within the securities finance market, the practical effect of the new rules was a topic much discussed at the February 2017 meeting of securities financiers run by the Information Management Network (IMN).
"Lenders are unaware that borrowers are assigning a risk metric to lenders. If you are an under-funded pension system, you might not be that attractive [to counterparties]. It's up to us as agent lenders to get our borrowers comfortable with our lenders," said Tim Smollen, global head of agency securities lending at Deutsche Bank in New York City.
There was tacit agreement among bankers at the IMN conference that there have been benefits to the new regulations. For example, new rules encouraging central clearing of derivatives allow the monitoring of accumulated debits among swap dealers and their customers. That’s generally considered a positive. No one wants a repeat of the experience in 2008 when the hidden exposures of AIG’s derivative positions threatened to topple the capital markets.
During the crisis, the largest broker-dealers merged with banks or became banks themselves. As a result, broker-dealers became subject to the banks' new capital rules. But those rules don't always fit the way brokers operate. For instance, holding cash was once considered the safest collateral. Now it's charged against a broker-dealer's net stable funding ratio. Just as the banks don’t want the indemnified assets ramping up their leverage ratios, their dealer subsidiaries don’t want the short term loans charged against their net stable funding ratios.
Relationships remain central to successful banking services. And, for that account, rules to improve market transparency and other developments are allowing agent banks to develop ties with related profit centers in their larger customers.
"We're developing relations with portfolio managers," said Mr. Smollen. In part, the banks’ research makes that possible, since investors are always hungry for alternate views on market conditions. The banks use the new working relationships to help keep securities lending from interfering with their customers’ portfolio strategies.
More servicing linkages among bankers and customers raise the possibility that the servicing agent may actually become a "control person" with indirect liability if a customer’s actions injure its own customers. New contract terms are helping to control that risk, but there’s been no court test yet.
Extension of the relationship is important for agent banks partly because the presence of the Federal Reserve in the short-term funding markets has shifted business that might otherwise go to the banks.
"Borrowers have access to the Fed, and we don't," said Mike Saunders, head U.S. trader at BNP Paribas in New York City. As a result, he said, borrowers have shifted some of their borrowing demand from the agent banks to the Fed. "Our solution is to do both sides with the same counterparty – so long as it fits the guidelines. Lenders can also expand their counterparties by accepting non-cash collateral.”
The non-cash pricing differential can be 8 to 10 basis points over cash collateral for the same position. According to recent data from FIS ASTEC Analytics, the average lender can make 10 basis points overall on its lendable assets. Therefore, the acceptance of non-cash collateral can double the fund's annual return. That collateral flexibility can also be applied to exchanges of high-quality liquid assets for other non-cash, generating additional fees for the collateral upgrades.
"With proper margins and haircuts, sovereign wealth funds will do collateral upgrades,” said Mr. Saunders. “We are seeing a great deal of volume."
Those who fear that more transparency between financial firms could result in price-fixing or other antitrust behavior can take comfort in an observation from Craig Starble, CEO of eSecLending, a Boston-based fintech firm: "We get a variety of bids for the same portfolio. If it’s a fixed income or equity allocation we will get different prices.” The portfolio’s composition is important, as is its collateral requirements. “We have to show the benefit to accept non-cash collateral, on a price-capacity basis."
"There are now some deals where, if you won't take non-cash, [borrowers] won't deal with you," Mr. Smollen told the IMN audience of institutional securities lenders. "We are reengineering our systems to handle non-cash collateral and complex transactions."
COSTS OF THE NEW RULES ARE RISING
Agent bank systems in the United States were designed to handle overnight loans and cash collateral. As a result, term loans and non-cash collateral require costly system enhancements, especially if illiquid securities and exotic instruments are acceptable as collateral.
“Our biggest problem is the quality of the data,” said a Treasury Department official at the IMN conference. The banks generate data for regulatory requests from the same systems used to process transactions and reconcile the books of the banks. The format is dictated by the banks’ commercial needs, not anticipated regulatory demands.
To support the due diligence responsibilities of customers, bankers are reaching out to the compliance departments of their customers to help improve their service and counterparty profiles.
 Research shows that traders who sell shares “short,” i.e., without owning the position, help markets to avoid runaway pricing bubbles. Traders also borrow securities to avoid delivery fails from short sales, thereby lowering operational risks for all investors.
 See e.g., Fed Report Finds Regulation Harming Repo Markets and Liquidity and Fed Finds Serious Liquidity Flaw in the Volcker Rule