September 16, 2016

Arbitrage and the Leverage Ratio

Ever since the dramatic banking collapse in 2008 Regulators and Central Banks have been pre-occupied with finding the magic bullet that prevents another systematic financial crisis arising in the future. 

Ever since the dramatic banking collapse in 2008 Regulators and Central Banks have been pre-occupied with finding the magic bullet that prevents another systematic financial crisis arising in the future.

And since that bullet doesn’t actually exist the inevitable focus has been on beefing up capital requirements, increasing transparency, clearing and margin.

Regulators require many ratios to be fulfilled including:

  • Capital adequacy ratio: minimum total capital ratio at 8% and tier 1 capital ratio 6% of RWA;
  • Minimum leverage ratio as defined by Tier 1 capital/ Total leverage exposure of 3%
  • CVA capital charge to reflect the capital needed to cover for fair value variations of CVA stemming from changes in the creditworthiness of the relevant counterparties
  • Capital conservation buffer of 2.5% or common equity tier 1
  • Liquidity coverage ratio as defined by Stock of high quality liquid assets/ Total net cash outflows over the next 30 calendar days > 100%
  • Net Stable Funding Ratio as defined by Available amount of stable funding/ Required amount of stable funding > 100%
  • Capital Requirements for bank exposures to central counterparties require Clearing Member Banks to set aside a default fund based on total trade exposures.

The results of this is an increased level of capital to be set aside with limited usage that puts pressure on the banks’ profitability. Capital management has probably never been more important for banks than it is today. Worldwide, and especially in Europe, the industry is confronting a severe capital shortage, driven primarily by new regulations and the increased volatility of financial markets. Even with the higher capital requirements imposed by regulation, rating agencies and many investors, in particular bondholders, want banks to carry a stronger capital buffer, over and above regulatory minimums. But they remain concerned about the difficulty of raising more capital and about the further dilution of investors’ shares.

Adapt or Die

To adapt, banks are accelerating a wind-down or restructuring of capital-inefficient trades through compression activities. The act of compressing trades decreases notional outstanding volume, as offsetting transactions are cancelled out, or netted without affecting risk profile on a portfolio level. Eventually, banks say, this and other moves will release up to 30% of Basel III RWAs. But some strategic opportunities to develop capital-focused business models have not yet been fully explored.

How does compression of interest rate derivatives save the bank’s capital and how to quantify the savings? One of the key elements is leverage ratio requirement.


The Leverage Ratio Exploded

The Basel III leverage ratio is defined as the capital measure divided by the exposure measure. See Figure 1.

Total Leverage Exposure = on balance sheet exposure + derivative exposure + securities financing transaction exposure + off balance sheet exposure

One of the components counts into the denominator total leverage exposure is derivative exposure.

The derivative exposure is the aggregation of replacement costs driven by current market value and collaterals and a PFE add-on, multiplied by an alpha of 1.4.

Replacement costs is the current Mark to market value of the assets net of cash variation margin when it is positive. Only cash variation margin is allowed to reduce replacement costs, initial margin is not. There are some discussions in the recent published consultative document on revision to the basel III leverage ratio framework, to allow initial margin offset on derivative exposures for client clearing business. However, this is subject to review and there is no amendment at this stage.

Since compression reduces the gross derivative exposure while keeps the net NPV and delta unchanged, the net MtM position before and after the compression remains the same. At the same time, the clients are facing the same counterparties with the same level of cash variation margins. Therefore, the first component of the derivative exposure, Replacement costs is unaffected by compression.

The capital savings from compression are from the second component of the derivative exposure, PFE add-on.

The AddOnaggregate is the aggregated effective notional on a gross basis. Compression reduces gross derivative exposure and eliminates matching trades from the opposite direction, therefore it reduces gross effective notional and reduces Addonaggregate.

The effective exposure is subject to a few pages of the regulatory rules with the details beyond drill down here, but we must point out that this is the entry point for compression services – reducing notional has a direct effect on the leverage ratio outcome.

The multiplier is adjusted to 1 for the calculation of leverage ratio purpose. However, in line with the standard approach framework, the effect of margining would continue to be reflected in the potential shorter time horizon or margin period of risk (MFi), ranging between 5 and 20 days, depending on whether the transaction was margined and centrally cleared as well as on the size of the netting set. 

If Master Netting Agreement is in place, the banks can net off transactions within the same netting set which will reduce their derivative exposure.


Capital Savings Across The Industry

Providing with the capital saving opportunities, banks are utilising compression services to shrink their exposure significantly. The derivatives market exposure was reduced to USD 553 trillion in June 2015 from its peak of USD 711 trillion in the first half of 2014. Aggregate compressions over the same period was of USD 265 trillion, three times as much as in the previous 18-months. So how much capital have we saved from the compression?

Using the default multiplier of 1, the USD 265 trillion notional compression over the 18 months’ period will lead to PFE add-on reduction of USD1.17trillion. If the bank keeps a minimum leverage ratio of 3%, the capital saving we observed during the period is around 3% x USD1.17 trillion = USD35bn.

Therefore, compression has effectively reduced the capital required to set aside to maintain leverage ratio above the minimum level. In the 18 months from 2014 to June 2015, compression has released an estimated USD35n for the industry which can then be used to generate higher revenue and higher return on equity for shareholders. Based on an average ROE of 8% among banks, the extra USD35n capital released could earn the banks an additional USD2.8bn revenue. 

On top of this, compression further reduces the default fund the banks are required to set aside with clearing houses.


Capital Requirements for bank exposures to central counterparties

The rise of clearing houses increases the gross notional trade volume, but also leads to a higher risk in case the clearing houses default. To cover the default risks of clearing houses, Basel III requires the banks to contributes towards a default fund, adds on another angle to banks’ capital consumptions.

There are two methods the banks can calculate their capital requirements. Most banks use method 2 which calculates RWA using 2% of trade exposure. The RWA is calculated on a trade by trade basis and the trade exposure is the gross trade exposure on each trade.

When trades are being compressed and matching opposite trades being eliminated, the gross trade exposures on the compressed trade disappear, leads to lower total RWA and reduce capital required.


Clearing Members Win Twice

Furthermore, the clearing members who guarantee clients’ trade exposures need to set aside an additional 2% of trade exposure to cover the clients’ default risk, effectively increase the risk weight to 4%. Therefore, for these clients, the capital saving from compression through default fund is doubled.


Compression Is The Way Forward

Given the huge capital saving benefits compression can provide through leverage ratio and default fund reduction, it is not difficult to see why compression activities has been on the rise in recent years.  Compression does not change the client’s risks on a portfolio level, leaving NPV and delta unchanged. It creates a rare win-win scenario that allows banks to reduce its derivative exposure and manage capital more efficiently, drives profitability and return on capital for shareholders, as well as reduces total market size and eliminates double counting for the regulator. 

This article was first published in edition 7 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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