EU still undecided on how to implement minimum repo haircuts

Concerns over non-bank leverage may derail push to include haircuts in bank capital rules

EU undecided over FSB repo haircuts regime

European Commission officials are still debating whether to include minimum haircuts for securities financing transactions in the bloc’s new capital requirements regulation, which is due to be published in less than three months.

The European Banking Authority is pushing for the rules to be incorporated into financial markets regulation instead – for instance, through a ban on transactions with insufficient haircuts. The regulator warned in 2019 that enforcing the minimum haircuts via bank capital requirements could lead to repo activity shifting to non-banks.

“We should recall the overall objective is to avoid the build-up of excessive leverage outside the banking system, and the question is how you technically implement this in a good fashion, with clear and operational rules,” says Lars Overby, head of risk policy at the EBA.

The minimum haircuts are designed to prevent repo lenders from offering excessively optimistic valuations of securities posted as collateral. Financing transactions with haircuts that are too low could face procyclical margin calls during bouts of volatility. Counterparties that are unable to meet those margin calls will be forced to close out those trades, potentially triggering a fire sale of collateral.

The Financial Stability Board announced in September 2020 that the minimum repo haircuts regime would be delayed by one year due to operational challenges posed by the Covid-19 pandemic.

The EC had originally planned to include the haircuts in the draft version of its third capital requirements regulation (CRR III). This was also postponed by a year due to Covid-19 and is now expected to be published in mid-2021. However, Risk.net understands the EC is still considering the EBA’s proposal to strip the haircuts from the package.

Concerns about collateral haircuts escalated after a mass unwinding of leveraged hedge fund trades caused major disruptions in the US Treasury market in March 2020. An FSB review of the market turmoil in March 2020, published in November, found “leveraged non-bank investors” were a significant part of the problem. The renewed focus on non-bank actors has bolstered the EBA’s argument for implementing the minimum haircuts regime through markets regulation, rather than bank capital requirements.

“I agree with the objective of curbing excess leverage outside the banking system, but it is not clear if the minimum haircut will be effective if it does not prevent regulatory arbitrage – this is the essence of the warning made by the EBA,” says Denis Beau, first deputy governor of the Banque de France and chair of the FSB’s analytical group on vulnerabilities.

“To prevent such arbitrage, it needs additional measures such as on the treatment of non-bank to non-bank transactions, which should be similar to [the treatment] of bank to non-bank transactions, and the implementation needs to be co-ordinated internationally.”

The EC declined to comment.

‘Lobbying hard’

The original FSB framework gave national regulators the choice of introducing minimum haircuts through bank capital requirements or markets regulation. The former approach would treat trades that fail to comply with the minimum haircuts as unsecured loans for capital purposes. With the extension in 2020, the deadline for implementing minimum haircuts through capital requirements is January 2023. Regulators that choose the market regulation route have until January 2025 to finalise their rules.

If the EC opts for markets regulation, the next step would be to ask the European Securities and Markets Authority – and possibly a macroprudential authority such as the European Systemic Risk Board – to provide advice and eventually a draft delegated act.

lars overby
Lars Overby: “The overall objective is to avoid the build-up of excessive leverage outside the banking system”

Repo market participants may well prefer this option. the International Capital Market Association’s European Repo and Collateral Council backed the idea of introducing haircuts through markets regulation in their response to an October 2019 public consultation by the EC.  

A former senior repo trader at a global bank says market participants have generally accepted that minimum haircuts will be introduced for asset classes such as credit and emerging market securities. But they are “lobbying hard for an exception from minimum haircuts for high-quality liquid asset collateral” to avoid further constraints on repo market liquidity and volumes.

An efficient repo market for high-quality liquid assets is essential to the operation of the Basel liquidity coverage ratio (LCR), which assumes that banks can easily convert certain holdings into cash even during periods of market stress.

“As a general rule, the management of haircuts and their volatility during stress times like the Covid-19 crisis is pretty dynamic and participants were by and large responsible and responsive,” says the former repo trader. “Most credit collateral haircuts catered for ample protection during tight liquidity and were higher than the minimum levels in most cases.”

The EBA’s Overby says the LCR itself reduces the risk of repo margin calls driving a liquidity squeeze in the banking sector. For that reason, he argues that markets-based regulation should be focused on non-bank entities rather than the banks themselves.

“The interaction with other pieces of legislation needs to be considered. This is also why the rules focus more on shadow banking – because many of the elements are already embedded in banking regulation,” says Overby.

Regulatory arbitrage

Overby sees no real reason for the EC to rush implementation of minimum haircuts in CRR III. The 2025 deadline for introducing the regime through markets regulation leaves plenty of time to adopt legislation at a later date. There is little sign of other jurisdictions rushing to implement the regime early, and Overby agrees with Beau that international co-ordination is vital.

“We need to have a framework that is implemented similarly across all jurisdictions, otherwise you are just introducing regulatory arbitrage linked to the booking place of your trades,” says Overby.

However, that may prove elusive if the EC does indeed adopt the framework as markets regulation. Risk.net understands that the Bank of England still plans to include minimum repo haircuts in a new set of bank capital regulations that the UK authorities are referring to as Basel 3.1 (which will consist of the reforms agreed at Basel in December 2017). The regulator intends to consult on this package in late 2021. If the BoE pressed ahead with its plans, that could leave the UK repo haircuts framework at odds with the EU regime.

The BoE declined to comment on its implementation of the minimum haircuts regime.

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