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Since the end of July 2023, when the Fed, FDIC, and OCC released their long-awaited proposal to implement the final components of the Basel III agreement, also known as Basel III endgame, banks and other interested parties have been actively assessing its impact.
A notable area of change relative to the Basel framework and implementations in other jurisdictions concerns securities financing transactions (SFTs), which are financial transactions where securities are used as collateral to borrow cash or other securities, including repurchase agreements (repos) and margin loans. The collateral typically has a haircut or percentage cut to its value applied depending on the riskiness or potential volatility of the asset used as collateral. Collateral requirements can be aggregated for a netting set of transactions with a particular counterparty.
The Basel III endgame proposal introduces a haircut floor, or a minimum amount of collateral banks must receive from unregulated financial institutions (UFIs) for certain SFTs that are not centrally cleared. Banks that fail to meet the haircut floor for in-scope transactions would have to treat those exposures as unsecured and receive no collateral benefit for capital calculations, resulting in materially higher capital requirements for those transactions. The proposal provides three potential exemptions to meeting the haircut floor but would still complicate risk weighted asset (RWA) calculations and SFT operations for U.S. banks relative to those in the EU and UK, where haircut floors were excluded entirely in their implementation of Basel III. This could have a significant impact on the liquidity of bonds and stocks, which are utilized in the approximately $5 trillion U.S. repo and €2 trillion global securities lending markets.1
Although the implications may vary depending on a firm’s business and client base, there are several aspects of the proposed minimum haircut floor that will impact the management and economics of SFT exposures:
- Banks would need to continuously determine whether counterparties and netting sets are in scope or out of scope.
- The governance and documentation needed for exemptions could be onerous for banks to implement and customers may not be willing to make the required representations.
- Failure to maintain collateral above the haircut minimum for in scope transactions could generate potentially volatile swings in capital requirements.
- Each of these new obligations could result in reduced market liquidity and some borrowers moving transactions to counterparties not subject to the haircut floor (e.g., non-banks).
With the regulators having recently extended the comment period for the proposal until January 16, 2024, it is likely that banks will comment on the implications of the proposed minimum haircut floor for the domestic SFT market and its global competitiveness.
In this Our Take Special Edition, we will explain the operational challenges and the RWA impact of the Basel III endgame SFT provisions as well as potential solutions for banks to consider.
1. Based on data from the International Securities Lending Association and the Securities Industry and Financial Markets Association.
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