Uh Oh Moments: What's coming next?

In line with the market's deliberations around systemic risk, central clearing, and its subsequent impact to demand/supply dynamics around collateral assets, BIS Committee on the Global Financial System recently released a paper on "Asset encumbrance, financial reform and the demand for collateral assets"on 27th May. As I poured through the pages of this well-constructed report, there were a couple of "Uh Oh" moments in my head as I examined the paper's key policy (and eventually, market) implications. Here's what caught my eye: 1) Disclosures on asset encumbrances: "Market discipline can be enhanced by requiring banks to provide regular, standardised public disclosures on asset encumbrance... Such disclosures would include information on unencumbered assets relative to unsecured liabilities, on overcollateralisation levels, and on received collateral that can be rehypothecated... Supervisors, in turn, should receive more detailed and granular data, as required, including the amounts and types of unencumbered assets."

Uh Oh #1: More granular regulatory reporting and requirements around the level of "free" assets on an institution's balance sheet look to be coming. There are profound implications for how financial firms manage and inventorize the components of their assets, liabilities and shareholders' equity at any given time (including collateral).

2) Risk-sensitive deposit insurance: "... deposit insurance schemes could be made risk-based (e.g. through the inclusion of a dedicated risk premium in deposit guarantee pricing), taking into account the funding structure of insured institutions in normal times. The pricing could differ depending on... resolution rules."

Uh Oh #2: "Pricing in asset encumbrance in deposit insurance schemes" seems to imply regulatory capital/RWA increases, through Basel IV or sooner through Basel III.5??

3) Expansion in scope of stress testing: "...banks should be asked to perform regular stress tests that evaluate encumbrance levels under adverse market conditions."

Uh Oh #3: Expansion of dimensions to stress test - in this case, related to asset encumbrance levels, funding scenarios and collateral frameworks. Institutions need to ensure stress testing practices are sustainably repeatable and sufficiently automated.

4) Oversight and possible regulation of the currently unregulated: "Central banks and prudential authorities need to closely monitor and oversee market responses to increased collateral demand and their effects on interconnectedness... in securities financing markets [e.g. securities lending, repo] and for shadow banking activities."

Uh Oh #4: There seems to be an undertone that anything "unregulated" is "bad" and risky. We anticipated this trajectory in our recent "Shadow Banking Products in Europe and North America" report and highlight how different products are used, risk management implications and technology advancement opportunities that various products may represent in the coming years. What's coming could include the possible central clearing of securities lending and repo activities, more position/exposure reporting, restrictions on re-hypothecation of assets and other forms of transparency reporting, etc.

One wonders if regulators are now stepping into the territory of choking economic activity. Do we really need to fix what is not really broken? Is transparency for transparency's sake necessarily beneficial to the way markets operate?

5) Extend of collateral rehypothecation permitted: "A particular aspect that has received considerable scrutiny in the policy debate on securities financing markets is the extent to which rehypothecation activities should be permitted. The recent crisis experience suggests that greater reliance on rehypothecation in financial intermediaries’ balance sheets will increase interconnectedness and make them more vulnerable to financial shocks. Rehypothecation of client assets can also delay the recovery of assets or even impose losses on beneficial owners."

Uh Oh #5: "Interconnectness" of the financial system is a concern, but it is also inevitable given the manner capital, derivative market reforms and collateralization rules are implemented. Instead of working to stop this interconnectedness from happening, regulators could do well to put in place "in-time circuit breakers" in the financial system to only "trip" when stress scenarios and adverse market conditions bubble up (pardon the pun).

Whilst the above points remain "thinking points" and nothing is concrete, it does provide us with a possible glimpse of what is coming. If we think that regulatory burdens in the financial industry are onerous now, regulators are only getting started! Keep your strategy nimble and technology sufficiently flexible - built not just for current requirements, but for future changes. These changes may come sooner than you think! -------------- For more detailed perspectives, please see the following: Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies Shadow Banking Products in Europe and North AmericaEquipping the Front Office for the New Risk Environment Cracking the Trillion Dollar Collateral Optimization Question Strength Under Fire in Risk Management