CRD IV has leaked: is it fatally flawed for the real economy?

July 13, 2011

The risk of ‘winning the battle but losing the war” on the exemption from central clearing of OTC derivatives for non-financial end users now seems to be coming home to hit us, despite the success we have had in Brussels (on EMIR) and our US counterparts have had in Washington (on Dodd-Frank).

We have now had (unofficially, of course) sight of the European Commission’s proposals in CRD IV for the future capital requirements regime for banks – the EU’s implementation of Basel III. We had always feared that Basel III would have the economic effect of making the use of non-cleared OTC derivatives economically unattractive, thereby discouraging the real economy from mitigating the financial risk (on currencies, interest rates and commodities) inherent in doing business. The wording of CRD IV confirms those fears.

The CRD IV proposal is due to be adopted by the College of Commissioners on 20 July. The wording of the proposal seems fundamentally flawed and an urgent campaign is now needed to underline this. The essence of this flaw is that CRD IV will, if enacted, penalise bank business in uncleared derivatives more highly than the equivalent business in direct lending. There is no logic to this. A further flaw appears to be that there will be greater reliance on active and liquid credit default swap (CDS) markets, whose use might reduce the impact on some companies of the higher capital requirements. In practice this looks likely to increase rather than reduce systemic risk. For those companies such as SMEs for whom there is no CDS market the implications are bleak.

I am indebted to colleagues for their analysis of the CRD IV proposals and will simply attempt to summarise the core argument. Banks use the concept of a Loan Equivalent Value (LEV) to measure the credit they are extending for any given financial product. Logically the capital requirement should be the same for any given level of LEV. Under the CRD IV mechanism there is no certainty that this will be the case. In determining the LEV a bank will have to look at a historic period of up to 500 days and run calculations that in effect take the highest CDS spread during that period, using a demanding 99% confidence level. For many companies this calculation will embody a much ‘worse’ credit assessment than their current underlying position justifies.

So we look as though we could be back where we began, with non-financial companies discouraged from doing the sensible and right thing, which is to use derivatives to offset some of the otherwise uncontrollable risks they face in doing business. Less hedging through derivatives means greater business volatility, reduced employment and growth. It’s as simple as that.

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