ISDA CEO Encourages Basel Committee to Re-Open Its Leverage Ratio Rules (with Lofchie Comment)

Concerned with the integrity of customer accounts, ISDA CEO Scott O'Malia criticized the Basel Committee on Banking Supervision for using a leverage ratio that doesn't take client margin protections into account when determining the exposures that banks face as a result of their client clearing businesses. O'Malia posted his opinion titled "Client Margin Protections Should Be Recognized" on the ISDA blog, derivatiViews.

Mr. O'Malia discussed what he asserts is a major shortcoming of the Basel Committee on Banking Supervision's "leverage ratio"; i.e., that margin provided by customers in respect of derivative clearing is treated as an asset of the bank in spite of the fact that the margin is legally segregated from the bank's assets and is not available for use by the bank (or its subsidiaries). He reported that when he had served as a CFTC commissioner, the CFTC had "worked to strengthen that protection [of client cash collateral serving as margin], and issued strict rules to ensure the integrity of customer accounts and restrict their access by futures commission merchants." The bank regulators' leverage ratio, he argued, "does not take these client margin protections into account when determining the exposures that banks face as a result of their client clearing business." He called this "a major flaw in the application of the leverage ratio."

Mr. O'Malia acknowledged the importance of introducing a simple measure that captures the on- and off-balance-sheet sources of leverage faced by a bank. He argued that properly segregated client cash collateral is not a source of leverage and risk exposure. Mr. O'Malia contended that properly segregated client cash collateral actually "reduc[es] the exposure related to a bank's clearing business by covering any losses that may be left by a defaulting client." This exposure-reducing effect is not recognized by the leverage ratio, he arguedo.

Mr. O'Malia concluded his commentary by encouraging the Basel Committee to re-open its leverage ratio rules and reconsider this issue.

Lofchie Comment: The notion that a clearing firm should be required to treat segregated margin, to which the clearing firm has no access, as if it were an asset of the firm for purposes of the leverage ratio, can only be explained by the proclivity of the bank regulators to view all financial activities as if they were traditional bank deposit and lending activities. This misguided "conservatism" by the bank regulators might conceivably be justified if it would make the economy safer. In fact, by raising the cost of hedging activities based on an impractical measure that cannot be readily defended, it discourages hedging and thus makes the economy more fragile.

See: ISDA derivatiViews Post, "Client Margin Protections Should Be Recognized."
Related News: MFA Submits Final Letter to BCBS Regarding Concerns with Basel III Leverage Ratio for Cleared Derivatives (with Lofchie Comment and Music Selection) (January 8, 2015) FRB, FDIC and OCC Adopt Final Rule to Strengthen Leverage Ratio Standards for Large Banks (April 8, 2014).