52 seconds capital

Month: May 2024

Remember the Repo Crisis of Sep 2019?

Overnight money market rates had spiked and showed significant volatility, with the SOFR spiking up from 2.43% on Sep 16 to 5.25% on Sep 17. (Refer image; Source: www.federalreserve.gov)

The largest money market in the world had just experienced an unsettling liquidity squeeze! (.. a situation that was then only alleviated after the Fed announced an overnight repo operation, to be conducted on the morning of 17th, offering up to $75 billion against USTs and other govt. bonds as collateral).

The events of Sep 2019 would ultimately only serve as a precursor to the biggest liquidity shock ever experienced in the US treasury market ─ the dash-for-cash in March 2020.

Which might prompt you to think: Why would the biggest fixed-income market experience liquidity outages?

Consider this: The Fixed Income Clearing Corporation (FICC) is the sole clearer of Treasuries and at present just 13% of cash treasury trades go through it!

That’s a staggeringly low percentage; and does make the UST market vulnerable during periods of heightened stress.

Here’s how:

Presently, a large volume of cash treasury trades is bilaterally cleared: which means each party assumes a counterparty risk of the other and the settlement is directly between the two parties.

You can see straightaway the risk this form of clearing poses during a period of market stress.

What if one of the counterparty defaults?

And imagine the subsequent domino effect it could create on the world order.

The SEC has identified this [bilateral clearing] as a clear-and-present danger for liquidity seizing up in the UST markets and have rung in changes that would force larger volumes of trades through a Clearing House.

And how does a Clearing House reduce counterparty default risk?

Think of a Clearing House as an entity that sits between a buyer and seller in a trade and takes collateral from both to safeguard each party’s interests.

It’s not all hunky-dory though for all market participants: forcing a larger volume of trades through a Central Clearing House means the SEC has taken the axe to Hedge Funds running strategies related to basis trades ─ usually 100x levered trades that bet on a convergence in the prices of Treasury Cash-Futures.

Hedge Funds may not really have the same appetite for Basis Trades, since they will now be required to post cash as collateral.

By

Avinash Menon, CFA

Founder and CEO,

52 Seconds Capital Limited

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In July 2023, the Federal Reserve and other top US regulators, unveiled its own ‘gold-plated’ version of the Basel III norms.

The proposal was, almost immediately, heavily criticised by the US banking industry for going far beyond the Basel accord.

A closer look at some of those regulatory proposals do indicate that the US banking regulators might have overreacted (especially on the ramping up of risk weights on residential mortgages). But some of them ─ related to model and operational risks ─ are spot on despite the criticism, especially when viewed in the context of the failures of Silicon Valley Bank, Signature Bank and First Republic Bank.

All that in a while.

But first, the back story.

***

The Basel III guidelines were introduced in response to clear breaks in the regulatory apparatuses around the world during the GFC of 2008.

The crux of the Basel III norms is the CET1 ratio, which in simple terms is the ratio of the bank’s core capital over its risk-weighted assets.

The lower this ratio, the weaker a bank. And vice versa.

Refer image for capital requirements of large US Banks. (Source: www.federalreserve.gov)

***

Back to the July 2023 proposals from the US Banking Regulators:

While the proposal does not explicitly raise required capital ratios, it does so anyway through its impact on RWAs.

Consider, Residential Mortgages:

Currently, first-lien loans prudently underwritten, receive a 50% risk weight, while other loans receive a 100% risk weight.

Under the draft proposal, residential mortgage risk weights are set to be 20% higher than international standards.

Think about that: the increased mortgage risk-weights against the backdrop of US mortgages currently tipping the scales at $12.14 trillion (at close of Q3, 2023, source: LendingTree), representing about 70% of the US consumer debt.

Now you get an idea why the proposals have raised the industry’s hackles!

This is clearly an area that might get watered down when the US Banking Regulators release an amended draft.

But there are a couple of points in the current draft that could remain unchanged.

For one, the advanced approaches for calculating RWAs (currently used) could well be replaced with the expanded risk-based approach. Particularly since it looks to standardize the approach towards credit, operational and credit valuation adjustment (CVA) risk.

The other one, among others, that could stay ─ in a classic case of closing the stable doors after the horse has bolted ─ is the removal of the ‘AOCI opt out’ (SVB had opted out of the Accumulated Other Comprehensive Income (AOCI) requirement and hence none of the unrealized losses from its available-for-sale securities, largely USTs, were included in its capital).

While awaiting the regulator’s revised draft, safe to say that the US Banking Industry is on tenterhooks, sweating buckets, while enduring the long wait until August ─ a month fittingly referred to as summer’s last stand.

By

Avinash Menon, CFA

Founder and CEO,

52 Seconds Capital Limited

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