Regulators slap capital charges on derivatives

Wed Jul 25, 2012 12:59pm EDT

* Cleared trades to have 2 percent risk weight

* Charge for exposure to clearing default fund as well

* Rules start in January, reviewed later that year

* Perverse rise in equity from increased risks to end

By Huw Jones

LONDON, July 25 (Reuters) - Banks will be better off financially if they clear their derivatives to curb risk, regulators said on Wednesday, but participants in the $648 trillion sector that lay at the core of the 2007-09 credit crunch still face higher capital charges.

The G20 countries agreed just after the collapse of U.S bank Lehman Brothers in 2008, in which opaque derivatives played a part, that dealers should clear contracts where possible to aid transparency.

Clearing houses like LCH.Clearnet in London, Eurex Clearing in Frankfurt and DTCC in the United States are backed by a default fund in case one side of the trade goes bust.

Most derivatives are traded off an exchange and not cleared, but those that are do not presently incur a capital charge.

Under new global rules published by the Basel Committee on Banking Supervision, all derivatives trades will incur a capital charge -- a cost likely to be passed on by banks to end users -- but that for cleared trades will be much lower.

The committee said banks using clearing houses that meet all supervisory requirements, such as having a big enough default fund, will have a risk-weighting of 2 percent for calculating capital requirements on their derivatives trades.

That compares with a proposed margin of between 2 and 15 percent on uncleared derivatives trades.

The Committee said the rule will also apply to indirect clearing so that market participants who are not directly dealing with the banks who are members of a clearing house can benefit as well from a low charge on cleared trades.

The "nominal" 2 percent capital charge is intended to create a financial incentive to clear trades on derivatives such as interest rate and credit default swaps.

Getting the balance between the two charges right to keep the clearing incentive intact has been tricky for regulators.

To complicate the equation, the committee said on Wednesday there will also a capital charge on a bank's exposure to the clearing house's default fund.

This second charge can be calculated in two ways: a blunt 1,250 percent risk weight subject to an overall cap, or a risk sensitive approach that has already been consulted on.

Banks will now work out what the margining on uncleared trades and two capital charges on cleared trades will mean in practice for the economics of their business models.

Industry officials say it could mean banks will simply stop trading some contracts to avoid having to find more expensive capital to back them.

Damian Carolan, a financial services lawyer at Allen & Overy, said capital requirements for cleared business would be fairly onerous but the committee had listened to industry by offering a reduced margin period for contracts closed quickly.

"It also mitigates to some extent previous accusations that the overly onerous capital treatment of cleared client business flatly contradicted the political imperative to increase the use of clearing," Carolan said. Banks may end up having to play safe and hold more capital than strictly required when using some clearing houses, he added.

The Swiss-based Basel Committee, made up of central bankers and regulators from G20 countries, said charges on cleared trades will be imposed from January on an interim basis and will be reviewed in the course of 2013.

The rules are part of the wider Basel III accord that will force banks to hold more capital from January 2013, reducing the risk that taxpayers will have bail out ailing lenders in future.

The committee also announced on Wednesday it has tweaked a rule contained in Basel III to stop a bank's regulatory capital buffer being boosted if the value of derivatives holdings fall.

Banks value their derivatives according to the going market rate or fair value every quarter for accounting purposes. The committee said the change would be phased in between the start of 2014 and take full effect from January 2018.

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