The Tug Of War Between Central Banks And Regulatory Capital Rules

Colin Lloyd

8 May 2014

The following guest commentary is from Colin Lloyd, who has worked in the financial services industry for a number of years; he recently joined the advisory committee of AAIN - Asian Alternative Investments Network. He has worked in the financial and commodity markets since 1981.

Among his more recent roles, in 2006 Lloyd became head of investor relations for a managed futures fund. In 2010 he set up his own alternative investment consultancy advising hedge funds on sales, marketing and business development whilst assisting in the capital raising process. In 2011, Lloyd joined Mako Group to help develop Mako FX, a spot foreign exchange electronic communication network liquidity solution for banks and brokers.

In this article, he points out that for all the ultra-low interest rates employed by central banks since the 2008 financial crisis, the requirements that banks hold certain levels of buffer capital against future disasters has, in practice, squeezed credit to the private sector. As wealth managers scan the horizon for higher economic growth, while seeking yield for clients in a low-rate world, the insights of Lloyd’s comments are hopefully useful to readers.

This publication is pleased to include Lloyd’s comments but as always, stresses that it does not necessarily share all the opinions expressed here and invites readers to respond.

Since 2008 major central banks have cut interest rates and implemented unconventional monetary policies. Meanwhile, financial regulators have increased capital requirements and introduced legislation to reduce bank leverage. I would argue that the regulatory tightening has significantly eclipsed the accommodative policies of central banks. To understand why the recovery has been so protracted and growth so anaemic, this is a good place to start.

The accommodation of central banks, cutting rates and buying government bonds, has been too paltry to offset the negative impact of regulators. The regulatory announcements - which are tantamount to “imposition” - of higher capital, collateral and margin requirements, has also helped to increase the public sectors share of financial markets at the expense of the private sector. This might be good news for cash-strapped government treasury departments, bereft of tax receipts, but it crowds out the private sector. With government bond yields kept artificially low, the incentive for banks to lend to the private sector is diminished. Meanwhile companies, which would normally make capital investment during cyclical downturns, are discouraged from borrowing by the negative real interest rate environment – they fear the outcome of interest rate normalisation. Instead they buy back shares and pay special dividends.

Nonetheless, the effect of central bank QE, combined with share buy backs and special dividends, has finally fed through. Higher asset prices and the allure of cheap mortgage financing have dragged the US economy out of the mire. The UK, where, in relative terms, the QE experiment had been even larger, has followed suit and is now the poster child of G7 growth.

Sea Change
Now the Fed has begun to taper. In the spirit of “forward guidance” this policy was pre-announced by Chairman, Bernanke on 19 June 2013. To date, the tapering has been tentative and measured – from $85 billion to $55 billion per month. Bond yields, which had bottomed for the year in April 2013, surged on the initial news and have remained moderately elevated ever since. However, this year the recovery in the US housing market slowed and several other economic indicators appear to have stalled. More worryingly, emerging markets, significant beneficiaries of the excess Fed liquidity, caught a cold as the US sneezed.

The Fed, and other central banks, face a dilemma; how to reduce the size of their balance sheets without puncturing the economic recovery?

Regulatory redux
This is where the regulators come into the story. The Bank for international Settlements originally introduced its Basel III framework in 2010. Aimed at avoiding bank-runs it proposed:-

1.   Capital Requirements
Bank Equity - 4.5 per cent
Tier 1 capital – 6 per cent of "risk-weighted assets"
Additional capital buffers:-
Mandatory capital conservation buffer - 2.5 per cent
Discretionary counter-cyclical buffer – 2.5 per cent - at the discretion of national regulators in times of high credit growth
2.   Leverage ratio
Tier 1 capital divided by the bank's average total consolidated assets – 3 per cent

3.   Liquidity requirements
Liquidity Coverage Ratio – banks to hold sufficient high-quality liquid assets to cover total net cash outflows over 30 days
Net Stable Funding Ratio - to insure stable funding would cover a one-year period of stress
Back in Q2 2010 McKinsey estimated the additional capital European and US banks would need to meet Basel III requirements: -

European Banks

Tier 1 Capital - €1.1 trillion
Short-term liquidity - €1.3 trillion
Long-term funding - €2.3 trillion

US Banks

Tier 1 Capital- $870 billion
Short-term liquidity - $800 billion
Long-term funding - $3.2 trillion

New rules
In January 2013 BIS revised the rules. This reduced US long-term funding shortfall to $750 billion. It was the first step in the dilution process. In January 2014 the Leverage Ratio rule was relaxed, and last month they increased the maximum exposure to a single counterparty from 10 per cent to 15 per cent.

Some 95 per cent of derivative exposure in the US banking system is concentrated in the hands of just five institutions according to a recent report from the Office of the Comptroller of the Currency. Under the original proposal the main US banks would have had to reduce their exposures by $860 billion, under the new rules they are sufficiently capitalised to maintain their current exposures. The Clearing House, an industry group, estimates the 5 per cent increase in single counterparty exposure means banks risk exposure will double rather than increase six-fold by 2019.

The elephant in the room – OTC derivatives
According to the latest BIS semi-annual OTC survey, the total notional value of OTC contracts is $692 trillion, of which $425 trillion were Interest Rate Swaps .

Traditionally OTC derivative contracts were bi-lateral; banks seldom required collateral from other bank counterparties. Central counterparty clearing of OTCs, despite growing for a decade, only accounts for 35 per cent of IRS contracts. From 2015, under European Market Infrastructure Regulation all European institutions will be required to adopt CCP. US institutions are already subject to similar requirements under Dodd Frank VII.

Whilst the Fed expanded its balance sheet from $910 billion in September 2008 to $4.2 trillion today, the collateral required to support the $276 trillion of non-CCP IRSs is $11.04 trillion – that is nearly three times the size of the Fed’s egregiously expanded balance sheet. Banks could borrow collateral for margin but this will impact their Leverage and Liquidity ratios.

Before the sledgehammer cracks the nut
Has pressure from industry groups finally begun to turn the tide of regulatory tightening? It may still be too early to say, but, as central banks try to reduce their balance sheets, a reversal or postponement of regulatory tightening could more than offset the effect. As central banks normalise monetary policy I expect further regulatory dilution to more than offset the effect, it will also divert stimulus from the public to the private sector.