On 19 November, the US Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation approved a final capital rule for the largest US banks that requires them to adopt the standardized approach for counterparty credit risk (SACCR).
The rule must be adopted by those US banks which are mandated to use the Basel III advanced approaches (i.e., advanced internal ratings-based); other US banks may voluntarily adopt it. The advanced approaches banks include the eight US global systemically important banks: Bank of America, The Bank Of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase & Co, Morgan Stanley State Street Corporation, and Wells Fargo & Company, as well as Capital One, Northern Trust Corporation, PNC Financial Services Group, and U.S. Bancorp. Many of these entities are also benefitting from the Fed’s Repo operations, which are designed to provide additional liquidity.
Moody’s says as originally proposed, SACCR would have resulted in a modest increase in risk-based capital requirements for the largest US banks but a modest decline in their leverage ratio requirements. However, in the final rule US regulators made several revisions to the original proposal which we expect will reduce both capital requirements, a credit negative.
The final rule is effective on 1 April 2020, with a mandatory compliance date of 1 January 2022. In 2014 the Basel Committee on Banking Supervision adopted SACCR as an amendment to the Basel III framework and in October
2018 US regulators proposed requiring the largest US banks to use SACCR for calculating their derivatives exposure amounts. SACCR is a more risk-sensitive approach to risk-weighting counterparty exposures than the current method and also revises certain calculations related to cleared derivatives exposures, including the measurement of off-balance-sheet exposures related to derivatives included in the denominator of the supplementary (i.e., Basel III) leverage ratio (SLR).
In the final rule, US regulators have made certain revisions to the original proposal, including reducing capital requirements for derivative contracts with commercial end-user counterparties and allowing for the exclusion of client initial margin on centrally cleared derivatives held by a bank on behalf of its clients from the SLR denominator.
Regulators explained that the reduction in capital requirements for exposures to commercial end-users is consistent with congressional
and other regulatory actions intended to mitigate the effect of post-crisis derivatives reforms on the ability of such counterparties to manage risks. Additionally, the exclusion of client initial margin on centrally cleared derivatives is consistent with the G20 mandate to establish policies that encourage the use of central clearing. The revisions may also prevent cross jurisdictional regulatory arbitrage because they would align the US with regulations in the UK and Europe on this matter, which are key jurisdictions where many of the largest US banks operate.
Nevertheless, a reduction in capital requirements would allow firms to increase their capital payouts or add incremental risk in other businesses without needing to hold more capital. Regulators estimate that the final rule would result, on average, in an approximately 9% decrease in large US banks’ calculated exposure amount for derivatives contracts and a 4% decrease in their standardized riskweighted assets associated with derivative exposures. The final rule would also lead to an increase of approximately 37 basis points (on average) in banks’ reported SLRs. If all 12 US banks subject to this rule were to maintain their SLRs at current levels instead of letting them rise as they would under the final rule, it would lead to the removal of approximately $55 billion in Tier 1 capital from the US
banking system.
Regulators also estimated that the final rule would lead to changes in individual banks’ SLRs, ranging from a decrease of five basis points to an increase of 85 basis points. Regulators did not identify which bank would receive the largest benefit. Moody’s estimate that if one of the six largest US banks is the beneficiary of an 85-basis-point increase in its SLR and the SLR was previously its binding capital constraint, allowing it to return to its shareholders an amount of capital equal to the entire benefit, it would lead to a reduction of between $9 billion and $25 billion in capital at just one bank.
In addition, on 19 November, US banking regulators published a final rule that amends the supplementary leverage ratio calculation to exclude custody bank holdings of central bank deposits. The change will only apply to The Bank of New York Mellon, State Street Corporation and Northern Trust Corporation.
Although the amended calculation is credit negative because it will allow custody banks to reduce capital and still meet one of their regulatory requirements, the practical effect is limited because other regulatory capital measures, specifically post-stress capital requirements, constrain the banks.
The final rule reflects the implementation of Section 402 of the 2018 Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA). Although EGRRCPA primarily aims to reduce regional and community banks’ regulatory burden, it also identifies central bank deposits held by custody banks as unique. In particular, custody banks maintain significant cash deposits with central banks to manage client cash fluctuations linked to custody and fiduciary accounts. Typically, these client cash positions are funds awaiting distribution or investment, but they can spike significantly in times of stress when custodial clients liquidate securities.
Under the final rule, only the Federal Reserve, the European Central Bank or central banks of Organization for Economic Cooperation and Development member countries that have been assigned a zero risk weight under regulatory capital rules are considered qualifying central banks. The rule also defines a custody bank as any US depository institution holding company with assets under custody to total assets of greater than 30:1. This ratio precludes other large custody providers also subject to the supplementary leverage ratio, such as JPMorgan Chase & Co., from excluding central back deposits in their capital calculation, because unlike the three qualifying firms they are not predominantly engaged in custody and asset servicing.
Looked at in isolation, the final rule would allow BNY Mellon, State Street and Northern Trust to reduce their Tier 1 capital by roughly $8 billion in aggregate – a significant 17% reduction – and still maintain the same supplementary leverage ratios. However, that ratio is just one of many capital requirements.
Indeed, regulators’ own analysis of the supplementary leverage ratio revisions, based on 2018 data, indicates that the final rule is unlikely to reduce Tier 1 capital for any of the three affected holding companies because other capital requirements are more binding.
Specifically, performance of the banks’ capital requirements under the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) process has constrained them.
The future course of the custody banks’ capital positions is not yet clear because other aspects of the US regulatory capital framework remain in flux. In particular, regulators are developing a stress capital buffer, which we expect will be incorporated into the CCAR process. On balance, we anticipate that the custody banks are likely to face a capital regime that is less restrictive, though the extent of capital relief is still uncertain.
However, the banks’ reduced supplementary leverage ratio requirement is an early indication of the likely trajectory.
