I blogged a couple of months ago about the future of the CVA exemption within CRD IV/CRR – the EU implementation of Basel III.  I was flagging concern about the attitude of the large US banks and the pressure being exerted by them on their trade association (SIFMA), on the US Treasury and through both these channels on the BIS.

I wrote in the name of the EACT to JPMorgan seeking reassurances that the bank was not seeking to “kill” the CVA exemption.  You can read my letter here.  The reply from the bank is available here.  The bank‘s corporate customers will I am sure decide for themselves whether they feel comforted by what is said.

Whatever the pressure from the US banks there are undoubtedly reasons to worry about the future of the CVA exemption.  Buying into the theory that smoke is generally linked with fire, we hear stories suggesting that central bankers in a number of key countries are unhappy with the [favourable] treatment of uncollateralised bilateral derivative contracts.  it seems an age ago that we were making the arguments about focusing on systemic risk and encouraging regulators to recognise that non financial companies do not of themselves create systemic risk within the financial system.  Maybe we need to promote the same debate one more time.

More encouragingly, I understand that Brussels is ‘solid’ on the CVA exemption, even if it never had the support of the European Commission.  Equally clearly there are good grounds for believing that pressure on Europe from the US (through Basel) will fall on barren ground.  Such pressure would be seen in the context of the apparently large area of disagreement (outing this politely) that exists between Washington and Brussels on the next but crucial issues around extraterritoriality and global consistency in derivatives regulation.

So the real risk for the CVA exemption must be that the central bank community seeks to impose a purist implementation of Basel III.  Watch for signs of fire and not just smoke.


The Twelfth Night Basel announcement of a relaxation of the original proposals for the Liquidity Coverage Ratio (LCR) is interesting for the non-financial sector on at least two counts. But on two counts also it is challenging to write about the topic.

At one level raising doubts about the smartness as well as the detail of Basel’s proposals is a little akin to challenging motherhood or respect for the flag; we surely all want a more robust banking system, less capable of such egregious failures of prudence and basic competence than we have persistently seen over the last decades and most dramatically so in 2007/08.

The very complexity of Basel III and to lesser extents its predecessors creates the other challenge. No need for references to rocket scientists; all must know that mastering the detail of bank capital regulation is not for the faint-hearted nor for those whose daily lives are not directly touched by the subject.

So why does the LCR announcement look interesting to this layman?

Firstly, on the purely practical level the changes ease some of the pressures that Basel III imposes on the corporate world, quite apart from everything else happening in the economy beyond the financial sector. No need to repeat here the mantras about sustainable employment and growth being driven by the real economy, with productive capital investment delivering multiplier direct and indirect benefits.

Stay with me and I will simply note that in calculating the LCR banks need no longer make the theoretical and academic assumption that committed facilities will be 100% drawn within a 30 day period; the ratio is reduced to 30%. Common sense, you might be saying, but for evident reasons Basel is unmoved by mundane common sense.

The change in the basis for the LCR, taken together with the move to a phased introduction of the requirement (from 2015 to 2019), will be significant for the ability of banks to lend to the non-financial sector. As such we should welcome the proposals.

The second reason to be interested in the Basel announcement is I believe what it tells us about financial regulators and especially Basel and its community of central bankers. I first became involved with the implications of Basel III when we realised that it threatened to cut across the value of the corporate exemption from the G20 proposals (which would have shifted all OTC derivative transactions onto exchanges and into central clearing). I was told that the tablets of Basel were indeed immutably in stone; and I was told that Basel was an eco-system populated by central bankers with a resolute determination to talk to their own and certainly not to the non-financial sector.

I won’t rehash the story other than to say that – to the European Union’s credit – our arguments on the deleterious impact of CVA were heard and we believe we are now moving to an outcome on the EU’s implementation of Basel III (through CRD IV and CRR) that is sensible and valuable for the real economy.

The reaction to the news on LCR suggests that Basel actually listened – if not to our voice then at least to that of the banking sector. Rather too late perhaps……but Basel listened and recognised the argument.

Finally, some open questions that are I assume exercising minds in Brussels. Did the Commission have any inkling of the plans to soften the impact of the LCR requirement? Are the Commission, Parliament and Council now thinking through where this leaves the detail – in CRR – of the EU proposals? What now might be the timetable for implementation of CRR?

Very interesting developments in the long-running saga of the Basel III implementation within the EU – our old friends CRD IV and CRR. The EACT and many corporates have been arguing that it is illogical and unhelpful to allow CRD IV/CRR to override economically the value of the corporate exemption under EMIR. The issue is specifically over the application of CVA, which in layman terms means how much additional margin is charged on uncleared bilateral OTC derivative contracts, to allow for the higher capital requirements proposed under Basel III and CRD IV/CRR.

When we started to argue that the EU should modify its implementation of Basel III we received essentially the same response that we had faced when we first started lobbying on the derivative regulations. That amounted to a polite (or on occasions, slightly less than polite) suggestion that we take our ball and go away and play elsewhere, as we were wasting our own and everyone else’s time. Naïvely or not we and others have persevered on both issues.

From the outset our argument on CRD IV/CRR has been that there should be a read-across exemption from CVA for EMIR exempt contracts – the economic effect of which would be to make it no more disadvantageous to benefit from the exemption. The first success was to obtain the support of ECON within the European Parliament. Since then the work on the proposals more or less disappeared into the mire that is officially described as ‘trialogue’; the latter is a process that often seems either extremely high-minded and democratic but sometimes looks to outsiders as crude nationalistic horse-trading at European level.

What I have been hearing in the last couple of days is that under the Cypriot presidency we are making real progress to obtain the read-across exemption for which we have been arguing. This is extremely good news for the real economy, even if there is a sting in the tail. That sting arises because the current proposal by Cyprus is to define the exemption in terms of whether or not the underlying transactions qualify for hedge accounting. In other words, the corporate would not be able to rely on the wider (and more sensible) approach under EMIR; that approach uses the test of whether a transaction is “objectively measurable as reducing risk”.

This is somewhat frustrating to see hedge accounting being brought back onto the table. On EMIR we had to argue early in the process that hedge accounting should not be the necessary condition for an exemption. Quite simply, this would be a nonsense for two reasons: firstly, there are sound risk mitigation reasons why on occasion companies will not be able to use hedge accounting; and secondly, it is inappropriate to base a regulation on transitory accounting standards.

On the assumption that what I have been hearing is indeed correct – and all the signs suggest that it is – we in the EACT will now vigorously pursue a campaign to confirm the read-across exemption and, most importantly, to explain why it is vital to remove the hedge accounting test.

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.