There was a collective sigh of relief across the derivatives industry over the Federal Reserve’s revised capital proposals which are seen as the most significant adjustment to US banks’ capital framework since the post global financial crisis reforms.
The central bank estimated that the relaxed new drafts of the Basel III and globally systematic important banks (GSIB) surcharge legislation would reduce capital levels at big US banks by around 4.8%. This was seen as a hard-won victory for the sector which vigorously lobbied to water down the central bank’s original 2023 plan that had envisaged 20% hikes.
The main concerns in derivatives circles were that proposal for bank capital rules would have forced them to hold excessive capital against client clearing exposures.
In fact, a January 2024 report by the Futures Industry Association (FIA) showed that the initial iteration would have translated into a $7.2 bn aggregate hit for the six largest US clearing banks. These include JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, Bank of America and Wells Fargo.
The result would not only have been restricted liquidity but paradoxically increase systemic risk for the $846trn derivatives market. This would go against the grain of the central banks main objective to curtail contagion and make the derivatives markets safer and more secure.
Red flags were also being raised over capacity constraints and the potential threats posed by concentrating the clearing business in a handful of dealers. Industry figures show a shrinking field with the six largest US banks accounting for roughly 80% of OTC swaps clearing services.
Over the years Deutsche Bank, Nomura, BNY Mellon, State Street and NatWest left the business which has become expensive and complicated. This was not only due to due to the regulatory capital, but also ongoing technological investment required.
Market participants believe that the new regulatory blueprint will make it easier for these players to stay in the clearing game. They include scrapping a requirement for these behemoths to hold 80% more capital against client exposures in their derivatives clearing units.
In addition, banks are exempt for client-facing derivatives clearing when calculating market risk scores that dictate how much regulatory capital US banks must hold. Moreover, they will be able to engage in cross-product netting of their risk exposures across derivatives and repo products, which should reduce the amount of capital they have to hold if positions across different products.
These widely expected changes are part of a broader capital overhaul marking the culmination of a years-long effort by Wall Street banks to ease rules introduced following the 2008 financial crisis, which they argue are stymying economic growth.
