US regulators are in the process of making important changes to the regulatory capital framework by proposing modifications to the enhanced supplementary leverage ratio, which should help stop it from acting as a non-risk-sensitive constraint on bank capacity – a change we strongly agree with. But we think regulators should make further modifications to the rules to avoid limiting the ability of banks to provide the intermediation services so vital to deep and liquid markets. A critical part of that is recognizing the risk-reducing benefits of cross-product netting.

Many banks have cross-product netting arrangements in place with counterparties that allow them to settle on a net basis across multiple transaction types, including derivatives and repo-style transactions, reducing credit risk between two counterparties. A growing focus on the efficient use of funding resources to support liquidity means these arrangements are becoming more popular, driven by client demand. But the US capital framework does not recognize the risk-reducing benefits of cross-product netting agreements under the standardized approach for counterparty credit risk (SA-CCR), the method all banks would have to use based on US Basel III endgame proposals. While cross-product netting can be recognized under the internal model method, this was not part of the Basel III proposals.

This matters. It means required capital is out of synch with risk, putting an unnecessary strain on bank balance sheets that may affect their capacity to provide liquidity, especially in stressed markets. This is particularly important in the context of the US Treasury market, where increasing issuance volumes – nearly $30 trillion and counting – means the ability of banks to offer intermediation services is more crucial than ever, while the introduction of the Securities and Exchange Commission’s clearing mandate from the end of next year will require banks to expand their client clearing offerings.

Initiatives by central counterparties to introduce cross-margining programs will bring significant efficiencies to clearing, helping to ease potential strains on market liquidity by ensuring the amount of initial margin posted reflects the actual risk of a portfolio of trades, even if those trades are cleared at two separate clearing houses.

Without similar recognition in the capital framework, banks would either need to ask a customer to post the full amount of margin to reduce their exposure – negating the benefits of cross-margining programs and putting a strain on market liquidity – or face a significant increase in capital requirements. This would reduce bank balance sheet capacity to facilitate the clearing of client transactions at a time when volumes of cleared trades will increase with the introduction of the Treasury clearing mandate.

While the lack of recognition of cross-product netting is particularly punitive when cross-margining arrangements are in place, the issue is much broader than that. The US capital framework should be appropriate and risk sensitive, and that means recognizing offsets in a portfolio of products when covered by a qualifying cross-product master netting agreement. Changes have been made to the documentation framework to allow firms to document derivatives and securities financing transactions under a single ISDA Master Agreement, reducing credit risk by expanding netting sets. It’s time the US capital framework followed suit by recognizing the reduced risk from cross-netting arrangements under a legally enforceable master netting agreement.

This will require revisions to the SA-CCR framework, most likely as part of the Basel III endgame re-proposal. Given SA-CCR feeds into other parts of the framework, including the supplementary leverage ratio, and at a time when regulators are focusing on accurate measurement and management of counterparty credit risk, we should take this opportunity to make SA-CCR more risk sensitive. This, in turn, will help enhance market liquidity and improve efficiency, especially during periods of stress.