ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Debt capital markets account for a massive 75% of total financing in the US, and banks play a critical role in keeping the wheels turning – they provide the intermediation and risk management services that enable US companies to cost-effectively raise the money they need for growth and investment. Unfortunately, analysis shows implementation of the US Basel III ‘endgame’ measures as currently proposed will make it much harder and more costly for banks to provide these services in future, which could reduce the liquidity of US capital markets and make it harder and more expensive for US businesses to raise funding.

The analysis, which we submitted last week as part of our response to the Basel III notice of proposed rulemaking, shows that market risk capital would increase by between 73% to 112%, depending on the extent to which banks use internal models. That’s a lot of extra capital, which we think is not justified by the levels of risk.

Put simply, the higher the capital required for a given activity, the more expensive it is to run that business. If capital levels aren’t aligned with risks and returns aren’t enough to offset capital costs, then banks will either choose to scale back from that business or raise costs. Neither are good for end users – particularly as the business lines that will be most affected are those critical to financing and hedging. Higher costs and reduced availability of funding will likely have a knock-on impact on US economic growth.

Ironically, global systemically important banks have weathered a series of market shocks, from the March 2020 dash for cash to Russia’s invasion of Ukraine. The main challenge faced during these events was not the viability of these institutions, but sharp reductions in market liquidity and capacity – a problem likely to be exacerbated by inappropriately large increases in capital for bank trading activities.

As part of our response, we propose a number of specific calibration changes to ensure the rules are more appropriate and risk sensitive and avoid a negative impact on the liquidity and vibrancy of US capital markets. These include greater recognition of diversification in the market risk framework to reflect actual risk exposure and changes to certain aspects of the rules for securities financing transactions (SFTs), including the removal of a SFT minimum haircut floor, which would make it more expensive for certain market participants to raise funding for meeting margin requirements on cleared transactions.

We also propose modifications to the credit valuation adjustment (CVA) framework, including an exemption for the client-facing leg of a cleared derivatives transaction from CVA capital requirements – something we think is unnecessary and would impact the cost of client clearing businesses.

If appropriate revisions to the calibration cannot be achieved without further consultation, a re-proposal of the rules may be necessary. But it’s important to recognize that these rules can’t be considered in isolation – regulators need to consider how the changes will interact with other requirements and policy objectives, including efforts to encourage central clearing and regulatory initiatives to resolve liquidity issues and capacity constraints in US Treasury markets.

The development of Basel III has involved significant work by regulators and market participants over a number of years. These changes will determine both the safety and resilience of banks and their ability to provide the financing, intermediary and hedging services critical to economic growth. We simply have to get this right.

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