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February 15, 2016

Compressions: a controlled risk to improve the leverage ratio under Basel III

The disclosure of the leverage ratio in Basel III has put pressure on banks to improve their capital levels. In April 2015 Commerzbank announced raising €1.5 billion in capital to improve its leverage ratio to 3.9%. Deutsche Bank’s Co-CEO Anshu Jain said that that the bank’s single most important strategy was to increase the leverage ratio from 3.4% to 5%. This article explains how compressions can also help banks to increase the leverage ratio while reducing their operational and credit risk.

The disclosure of the leverage ratio in Basel III has put pressure on banks to improve their capital levels. In April 2015 Commerzbank announced raising €1.5 billion in capital to improve its leverage ratio to 3.9%. Deutsche Bank’s Co-CEO Anshu Jain said that that the bank’s single most important strategy was to increase the leverage ratio from 3.4% to 5%. This article explains how compressions can also help banks to increase the leverage ratio while reducing their operational and credit risk.

One of the main drivers for the global compression activity in 2014 and 2015 has been to reduce the capital requirements under Basel III. This regulation mandates financial institutions to hold a minimum “Leverage Ratio” of 3%, or more for certain large banks. The ratio is a fraction with the Tier 1 Capital in the numerator and the credit exposures in the denominator.

Leverage Ratio under Basel III:

So a clever way to comply without the need of more capital is to decrease the denominator of the formula. One of the components of the denominator is the bank’s credit exposure due to derivatives. The notional values of an OTC derivative contribute to the credit exposure in absolute value terms. This means that every trade, buy or sell, adds-up to increase the denominator of the leverage ratio. Portfolios with a large number of transactions can enlarge the denominator and the capital requirements in the numerator to maintain the leverage ratio above 3% can be significant. Compressions terminate transactions early while keeping the profits and cash flows in a portfolio equivalent or almost equivalent to pre-compression levels. Once a transaction is terminated, there is no notional value. Which means that the denominator decreases, and the Leverage Ratio as a whole increases even if no capital is injected.

Credit Risk in Basel III

The methodology used to calculate credit risk under Basel III is called the Standardised Approach for measuring exposure at default (EAD) for Counterparty Credit Risk, or the “SA-CCR”, that is expressed with the following formula:

Where RC is the replacement cost of the derivative, meaning the market value; or in credit terminology the current exposure. PFE is Potential Future Exposure, which is the additional credit risk that is likely to happen in the future due to changes in market prices. PFE is the metric that benefits from compressions.

Basel defines PFE as a result of mathematical operations involving risk factors and the notional value of every trade. The following is based on one of the examples published in April 2014 where BIS explains how to apply the SA-CCR. The formula can be very complex, so I am focusing here on the notional values, which are the numbers that can be reduced with compressions. The notional value of a trade is the remaining units to be delivered under the transaction times the price.

After the compression:
If trades 1 and 2 are eliminated because they offset each other, the only transaction contributing towards the Total Effective Notional would be Trade 3.

The EAD is one of the components that contribute towards the denominator in the Leverage Ratio. The reader may see how the EAD after the compression is much smaller than before the compression. A much smaller EAD contributes less towards the denominator, resulting in an increased Leverage Ratio. This is a wonderful result considering that no capital has been injected!

Operational Risk and Compressions

Often, one of the key performance indicators in compressions is the number of “line items” or trades eliminated. Less trades mean less operational risk with less data to store, reconcile, manage, migrate and audit. However, operational risk is present during the compression itself. This is because different people from different areas of the business need to perform actions outside their normal routines, and modifications to the systems are required. A well co-ordinated compression is a change in a controlled environment. Once the project is completed, a company is in better shape to face changes that may happen when least expected or that are unavoidable. For example, a default that may require unwinding transactions is easier to value and challenge when there is less number of trades. A system upgrade is definitely easier if there is less data to migrate or validate. Reconciling collateral is quicker if the number of “line items” fit in a small spreadsheet.

The BIS reported that the gross notional value of interest rate swaps dropped by USD 65 trillion in the first quarter of 2015, largely due to compressions. TriOptima ran 120 multilateral compression cycles in 2014, largely driven by banks aiming at improving their Leverage Ratio to comply with Basel III.

The millions or hundreds of millions in capital savings have outweighed the operational implications of the compression tasks; and have been sufficient reasons for banks to incorporate compression cycles into their activities. Clearers and now swap execution facilities or SEFs are offering compressions to help firms with collateral requirements.

Sources:

  • Portfolio Compression, Techniques to Manage EMIR and other Regulatory and Trading Risks, by Diana Higgins, Risk Books, 2015
  • The Impact on Compression on the Interest Rate Derivatives Market, Research note by ISDA, July 2015
  • Basel III Leverage Ratio Framework and Disclosure Requirements, January 2014, by Bank of International Settlements (BIS). http://www.bis.org/publ/bcbs270.pdf
  • The Standardised Approach for Measuring Counterparty Credit Risk Exposures, April 2014, by Basel Committee on Banking Supervision, Bank of Internationals Settlements (BIS) http://www.bis.org/publ/bcbs279.pdf
  • Financial Times, April 27 2015.

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