Our Single Counterparty Credit Limit (SCCL) guide has what you need to know about the proposed rules capping aggregate net credit exposure which may impact the securities lending market.
Earlier this year, the Board of Governors of the Federal Reserve System (the "Board") issued a notice of proposed rulemaking implementing the provisions of Dodd-Frank Section 165(e). These rules, commonly referred to as the single counterparty credit limits (SCCL), cap the amount of aggregate net credit exposure that a large bank holding company can have to an unaffiliated entity or individual. The Board had previously issued proposed rules for comment in 2011. The Basel Committee issued its final standards for controlling large exposures in 2014. The Board’s proposed rules impose stricter requirements than the standards set by the Basel Committee, especially as they relate to securities finance transactions.
The proposed rules apply to U.S. bank holding companies and foreign banking organizations with a banking presence in the U.S.—including any intermediate U.S. holding company—that have $50 billion or more in total consolidated assets. This includes many of the large agent lenders as well as most of the top-tier borrowers in the securities lending market.
Under these proposed rules, the industry standard borrower default indemnification that agent banks provide to their clients is treated as a direct credit exposure to the securities borrower. Unlike the capital rules, these new limits do not simply increase the cost of indemnification but rather constrain the actual capacity of agent banks to offer this credit protection with respect to many of the large traditional borrowers.
The SCCL limits total credit exposure to a single counterparty to 25% of a bank’s regulatory capital. For global systemically important banks (G-SIBs), the rule limits total credit exposure to another G-SIB or a nonbank systemically important financial institution (SIFI) to 15% of tier 1 capital. Therefore, if the agent bank is a G-SIB and the borrower is also a G-SIB or a SIFI—which is the case for a majority of agent lending transactions in the market—the agent bank’s limit on credit exposure to that borrower is 15% of its tier 1 capital.
This 15% limit does not just include borrower default indemnification exposures but all other credit exposures that the agent bank or any of its affiliates have to the borrower and any of its affiliates. These can include exposures such as derivatives, deposit liabilities, wholesale funding, lines of credit, etc. Due to the volatility of some of these exposures, it is likely that affected institutions will maintain a buffer and will allocate the remaining limit among business lines. As a result, an agent bank’s securities lending business may only be allocated a portion of the overall limit.
As further evidence of the regulatory policy goal to direct more transactions into a centrally cleared environment, qualified central counterparties (QCCPs) are exempted from the SCCL. As a result, a covered institution has no limit under SCCL on the amount of credit exposure it can have to a QCCP. U.S. Treasury and other sovereigns that receive a zero risk weight under the existing U.S. capital rules are also excluded. This is an important exclusion due to the risk shifting provision described below that shifts risk to the collateral issuer. As a result, there is no limit on the use of debt issued by these sovereigns as collateral.
Under the proposal, credit exposure for securities financing transactions is generally measured using the collateral haircut approach, which is the same methodology used to measure credit exposure at default under the standardized approach for calculating risk weighted assets in the existing U.S. capital rules. In addition, the proposed rule has a risk shifting provision requiring that to the extent collateral is used to offset loan exposures, the offset credit exposure is shifted to the issuer of the collateral.
One of the major issues with the collateral haircut approach is that it grossly overstates the economic exposure for most securities lending transactions. Despite the fact that securities loans are required to be over-collateralized and despite historical experience to the contrary, the collateral haircut approach assumes that market prices of loan securities and collateral are perfectly negatively correlated. For example, Intel stock and Apple stock might be positively correlated, but the collateral haircut approach would assume that every dollar increase in the price of Intel stock on loan would follow a dollar decrease in the price of Apple stock held as collateral. Furthermore, the collateral haircut approach fails to take into account the risk-mitigating benefits of portfolio diversification. In contrast, the measure of credit exposure for derivatives contained in the proposal is much more flexible and arguably much more accurately reflects economic reality.
Largely as a result of the blunt method that the proposal uses to calculate credit exposure for securities lending transactions, agent banks could be forced to limit the circumstances in which they can provide borrower default indemnification. This could result in reduced levels of revenue across the market for lenders who require this protection. This reduced activity could also impact market liquidity especially in low-return asset classes. In addition, there may be increasing demand for synthetic alternatives to securities lending given the relatively favorable treatment of derivatives under the proposed rule. These synthetic alternatives may not be a viable option for many lenders. Similarly, one would expect a more pronounced move to central clearing for securities lending transactions once a viable model has been developed.
We expect this rule to become final by early 2017. It is likely that there will be an implementation period that could be as long as a year resulting in an effective date of early 2018. In the interim, BNY Mellon continues to work with other agent banks and industry associations such as the Risk Management Association to advocate for an alternative exposure calculation to the collateral haircut approach that better takes into account the effect of correlations between long and short positions and the benefits of portfolio diversification (such as the Basel Committee’s revised calculation methodology for securities financing transactions contained in their December 2015 proposal) so that agent banks can continue to provide borrower default indemnification.
The following is an example of the calculation of credit exposure under the collateral haircut approach contained in the proposed SCCL:
In this example, the agent bank lends main index equity securities with a market value of $100 on behalf of its beneficial owner client to a borrower. The borrower provides $108 of main index equity collateral. The currency of the securities on loan and the collateral is assumed to be the same. This example assumes that the equity securities provided as collateral are from a single issuer.
The collateral haircut applied to main index equities is 10.6% (under SCCL).
Agent Bank’s Credit Exposure to the Borrower
Agent Bank’s Credit Exposure to the Issuer of Equity Securities Collateral
Note: If the securities on loan are valued in a currency that is different from that of the collateral security, an additional exposure of 5.7% (under SCCL) would be added to the net exposure.
BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally. This material and any products and services may be issued or provided under various brand names in various countries by duly authorized and regulated subsidiaries, affiliates, and joint ventures of BNY Mellon, which may include any of the following. The Bank of New York Mellon, at 225 Liberty St, NY, NY USA, 10286, a banking corporation organized pursuant to the laws of the State of New York, and operating in England through its branch at One Canada Square, London E14 5AL, UK, registered in England and Wales with numbers FC005522 and BR000818. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the US Federal Reserve and authorized by the Prudential Regulation Authority. The Bank of New York Mellon, London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV, a Belgian public limited liability company, with company number 0806.743.159, whose registered office is at 46 Rue Montoyerstraat, B-1000 Brussels, Belgium, authorized and regulated as a significant credit institution by the European Central Bank (ECB), under the prudential supervision of the National Bank of Belgium (NBB) and under the supervision of the Belgian Financial Services and Markets Authority (FSMA) for conduct of business rules, and a subsidiary of The Bank of New York Mellon. The Bank of New York Mellon SA/NV operates in England through its branch at 160 Queen Victoria Street, London EC4V 4LA, UK, registered in England and Wales with numbers FC029379 and BR014361. The Bank of New York Mellon SA/NV (London Branch) is authorized by the ECB and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV operating in Ireland through its branch at 4th Floor Hanover Building, Windmill Lane, Dublin 2, Ireland trading as The Bank of New York Mellon SA/NV, Dublin Branch, is authorized by the ECB and is registered with the Companies Registration Office in Ireland No. 907126 & with VAT No. IE 9578054E. The Bank of New York Mellon, Singapore Branch, subject to regulation by the Monetary Authority of Singapore. The Bank of New York Mellon, Hong Kong Branch, subject to regulation by the Hong Kong Monetary Authority and the Securities & Futures Commission of Hong Kong. If this material is distributed in Japan, it is distributed by The Bank of New York Mellon Securities Company Japan Ltd, as intermediary for The Bank of New York Mellon. If this material is distributed in, or from, the Dubai International Financial Centre (“DIFC”), it is communicated by The Bank of New York Mellon, DIFC Branch, regulated by the DFSA and located at DIFC, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE, on behalf of The Bank of New York Mellon, which is a wholly-owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. Not all products and services are offered in all countries.
The information contained in this material is intended for use by wholesale/professional clients or the equivalent only and is not intended for use by retail clients. If distributed in the UK, this material is a financial promotion.
This material, which may be considered advertising, is for general information purposes only and is not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter. This material does not constitute a recommendation by BNY Mellon of any kind. Use of our products and services is subject to various regulations and regulatory oversight. You should discuss this material with appropriate advisors in the context of your circumstances before acting in any manner on this material or agreeing to use any of the referenced products or services and make your own independent assessment (based on such advice) as to whether the referenced products or services are appropriate or suitable for you. This material may not be comprehensive or up to date and there is no undertaking as to the accuracy, timeliness, completeness or fitness for a particular purpose of information given. BNY Mellon will not be responsible for updating any information contained within this material and opinions and information contained herein are subject to change without notice. BNY Mellon assumes no direct or consequential liability for any errors in or reliance upon this material.
This material may not be distributed or used for the purpose of providing any referenced products or services or making any offers or solicitations in any jurisdiction or in any circumstances in which such products, services, offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements.
Neither BNY Mellon nor any of its respective officers, employees or agents are, by virtue of providing the materials or information contained herein, acting as an adviser to any recipient (including a “municipal advisor” within the meaning of Section 15B of the Securities Exchange Act of 1934, as amended, “Section 15B”), do not owe a fiduciary duty to the recipient hereof pursuant to Section 15B or otherwise, and are acting only for their own interests.
All references to dollars are in US dollars unless specified otherwise.
This material may not be reproduced or disseminated in any form without the prior written permission of BNY Mellon. Trademarks, logos and other intellectual property marks belong to their respective owners.
The Bank of New York Mellon, member FDIC.
©2016 The Bank of New York Mellon Corporation. All rights reserved.
Managing Director and Global Head of Product Strategy, Securities Finance
BNY Mellon Markets
Mike McAuley is Managing Director and Global Head of Product Strategy for BNY Mellon’s Securities Finance program. He is responsible for leading the business’ efforts to identify and capitalize on new opportunities in a changing business, tax and regulatory environment.View Profile