Federal Banking Agencies Issue Final Rules Revising the Supplementary Leverage Ratio’s Exposure Measure Denominator
SUMMARY Earlier this month, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency (collectively, the “Agencies”) issued final rules (the “Final SLR Rules”) that revise the definition and scope of the “total leverage exposure” measure, which is the denominator of the new Basel III-based supplementary leverage ratio requirement (the “SLR”) that the Agencies adopted as part of their July 2013 comprehensive revisions to their regulatory capital rules (the “Revised Capital Rules”)1 applicable to U.S. banking organizations. Under the Revised Capital Rules, the SLR is calculated as the ratio of Tier 1 capital to total leverage exposure. When it becomes effective on January 1, 2018, the SLR will apply only to “advanced approaches banking organizations” that is, those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures.2 The Final SLR Rules revise the definition of total leverage exposure to: include the effective notional principal amount of credit derivatives and other similar instruments through which a banking organization provides credit protection (that is, sold credit protection); modify the calculation of the components of total leverage exposure for derivative and repo-style transactions; and conform the credit conversion factors (“CCF”) applied to certain off-balance sheet exposures to the graduated CCF used by the Revised Capital Rules’ standardized approach, subject to the minimum 10% CCF. -2- Bank Capital: Supplementary Leverage Ratio September 16, 2014 The Final SLR Rules also change the frequency with which certain components of the SLR are calculated and establish the public disclosure requirements for various items associated with the SLR. The amendments adopted in the Final SLR Rules are largely consistent with the final revisions (the “BCBS 2014 Revisions”) adopted in January 2014 by the Basel Committee on Banking Supervision (the “BCBS”) to the denominator of the Basel III leverage ratio (defined in Basel III as the “exposure measure”).3 The BCBS’ initial 2013 proposals to revise the exposure measure would have had the effect of substantially limiting banking organizations’ recognition of cash collateral as an offset to exposures under derivatives and repo-style transactions, notwithstanding that applicable accounting standards (whether GAAP or IFRS) permitted recognition of cash collateral. Although the final BCBS 2014 Revisions and the Final SLR Rules do not simply defer to accounting principles for circumstances when cash collateral may be recognized as an offset, both are expected to permit recognition of cash collateral as an offset to exposures under many derivatives and repo-style transactions. The Final SLR Rules were adopted unchanged as a substantive matter from the proposed rules included in the SLR proposal published for comment by the Agencies in April 2014 (the “SLR Proposal”) with one key exception: the Agencies modified the calculation of total leverage exposure so that off-balance sheet exposures included in the total leverage exposure are calculated as the arithmetic mean (that is, average) of such exposures as of the last day of each of the most recent three months (rather than the mean of such exposures as of each day of the reporting quarter as included in the SLR Proposal). The Agencies also included in the Final SLR Rules and/or the preamble thereto a number of clarifications in response to comments received on the SLR Proposal, including with respect to: the circumstances under which a banking organization could offset cash variation margin for purposes of measuring total leverage exposure; the criteria to reduce the effective notional amount of sold credit protection; the criteria for recognizing the GAAP offset for repo-style transactions; forward agreements associated with a repurchase or securities lending transaction that qualifies for sales treatment under GAAP; and circumstances when a clearing member banking organization would be required to include in total leverage exposure an exposure to central counterparties (“CCP”) for client-cleared transactions. The SLR is discussed in further detail in our memoranda to clients dated July 3, 2013, relating to the Revised Capital Rules,4 and April 16, 2014, relating to the SLR Proposal.5 This memorandum focuses on key modifications and clarifications set forth in the Final SLR Rules and the preamble. BACKGROUND As noted above, the Agencies adopted the SLR in July 2013 as part of the Revised Capital Rules. Under the Revised Capital Rules, a minimum SLR requirement of 3% applies to all advanced approaches -3- Bank Capital: Supplementary Leverage Ratio September 16, 2014 banking organizations. Under the enhanced SLR standards (the “eSLR standards”) finalized by the agencies in May 2014, U.S. top-tier bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under custody must maintain a leverage buffer greater than 2% above the minimum supplementary leverage ratio requirement of 3%, for an effective total of more than 5%, to avoid restrictions on capital distributions and discretionary bonus payments.6 Insured depository institution subsidiaries of such bank holding companies must maintain at least a 6% supplementary leverage ratio to be considered “well-capitalized” under the Agencies’ “prompt corrective action” regulations. Consistent with the Revised Capital Rules, under the Final SLR Rules, advanced approaches banking organizations will be required to disclose their SLRs beginning January 1, 2015, and will be required to comply with a minimum SLR capital requirement of 3% and, as applicable, the eSLR standards beginning January 1, 2018. KEY MODIFICATIONS AND CLARIFICATIONS IN THE FINAL SLR RULES A. CALCULATION OF TOTAL LEVERAGE EXPOSURE The Revised Capital Rules define the SLR as the arithmetic mean of the ratio of Tier 1 capital to total leverage exposure calculated as of the last day of each month in the reporting quarter. The SLR Proposal would have changed that calculation such that the numerator of the supplementary leverage ratio (that is, Tier 1 capital) would have been calculated as of the last day of each reporting quarter, while the denominator (that is, total leverage exposure) would have been calculated as the mean of the total leverage exposure calculated daily. Several commenters voiced concerns that the application of daily averaging to off-balance sheet exposures would introduce significant practical complexities with no offsetting compliance benefit. In recognition of this operational burden, the Final SLR Rules modify the calculation of total leverage exposure so that the total leverage exposure is calculated as (i) the mean of the on-balance sheet assets calculated as of each day of the reporting quarter, plus (ii) the mean of the off-balance sheet assets calculated as of the last day of each of the most recent three months, minus (iii) the applicable deductions under the Revised Capital Rules. The Agencies also removed the proposed reference to the calculation of Tier 1 capital as of the end of the quarter to avoid the implication that the supplementary leverage ratio is calculated only at the end of the quarter. The preamble to the Final SLR Rules notes that the Agencies will continue to monitor this issue and may revisit it at a future date if it is determined that monthly calculations of off-balance sheet exposure raises supervisory concerns. The Agencies also state in the preamble that they are evaluating the calculation methodology for the leverage ratio applicable to all banking organizations and may seek comment on a proposal applicable to advanced approaches banking organizations to align the methodology for calculating on-balance sheet assets for purposes of that leverage ratio and the supplementary leverage ratio in the future. -4- Bank Capital: Supplementary Leverage Ratio September 16, 2014 B. DEFINITION OF TOTAL LEVERAGE EXPOSURE Treatment of cash variation margin associated with derivative transactions. Banking organizations are required under the Revised Capital Rules to include in total leverage exposure the carrying value, if any, of derivative contracts on a banking organization’s balance sheet. While the BCBS’ initial proposals to revise the Basel III exposure measure would effectively have precluded U.S. banking organizations’ recognition of any cash collateral securing derivatives exposures, the Final SLR Rules, like the BCBS 2014 Revisions, permit recognition of cash variation margin if certain conditions are met. The Final SLR Rules specify the following five conditions that must be met for a banking organization to use cash variation margin only (that is, cash collateral received from and posted to a counterparty to a derivative contract but not initial cash collateral) to reduce the current credit exposure amount of a derivative contract: for derivative contracts not cleared through a qualifying central counterparty (“QCCP”), the cash received by the counterparty is not segregated (by law, regulation or an agreement with the counterparty); the variation margin is calculated and transferred on a daily basis based on the mark-to-fair value valuation of the derivative contract; the variation margin would fully extinguish the net current credit exposure to the counterparty of the derivative contract, subject to applicable threshold and minimum transfer amounts; the cash variation margin is in the form of cash in the same currency as the currency of settlement of the derivative contract; and the derivative contract and variation margin are governed by a qualifying master netting agreement between the counterparties to the derivative contract or by the governing rules for a cleared transaction, which in each case must explicitly stipulate that the counterparties agree to settle any payment obligations on a net basis, taking into account any variation margin received or provided under the contract if a credit event involving either counterparty occurs. These conditions are substantively identical to those proposed in the SLR Proposal. However, with respect to the first criterion, in response to commenters’ concerns that a banking organization that posts cash variation margin to a counterparty that is not a QCCP may not know whether that counterparty has segregated the cash variation margin that it received, the Agencies included in the Final SLR Rules the parenthetical “(by law, regulation or an agreement with the counterparty)” to clarify that, unless segregation is required by law, regulation or any agreement with the counterparty, a banking organization that posts cash variation margin to a counterparty may assume that its counterparty has not segregated the cash variation margin it has received for purposes of meeting this criterion. The Agencies further clarify in the preamble to the Final SLR Rules that “‘not segregated’ in this context means that the cash variation margin received is commingled with the banking organization’s other funds. In other words, the counterparty that receives the cash variation margin should have no unique restrictions on its ability to use the cash received ([for example], the banking organization may use the cash variation margin received similar to other cash held by the banking organization).”-5- Bank Capital: Supplementary Leverage Ratio September 16, 2014 The Agencies also clarify in the preamble that, to meet the second criterion, derivative positions must be valued daily and cash variation margin must be transferred daily to the counterparty or to the counterparty's account when the threshold and daily minimum transfer amounts are satisfied according to the terms of the derivative contract. This was in response to a commenter’s query as to whether the second criterion would be met for certain categories of derivative transactions, such as exchange-traded options and energy derivatives, where variation margin may not be exchanged daily, but is exchanged on a regular basis. Finally, the Agencies clarify that cash variation margin exchanged on the morning of the subsequent trading day (based on the mark from the end of the previous day) would meet the third criterion. Credit derivative exposures. The Final SLR Rules adopt as proposed the requirement that a banking organization include in total leverage exposure the effective notional principal amount (that is, the apparent or stated notional principal amount multiplied by any multiplier in the derivative contract) of sold credit protection. The following criteria, if met, would permit a banking organization to reduce the effective notional principal amount of sold credit protection by the effective notional principal amount of purchased credit protection: the remaining maturity of the purchased credit protection is at least equal to the remaining maturity of the sold credit protection and the following additional criteria are satisfied: for single-name credit derivatives, the reference exposure of the purchased credit protection would need to refer to the same legal entity and rank pari passu with, or be junior to, the underlying reference exposure of the sold credit protection (but, if junior, only if a credit event on the senior reference asset would result in a credit event on the subordinated reference asset); and for tranched products, the reference exposure of the purchased credit protection would need to refer to the same legal entities and rank pari passu with the underlying reference exposures of the sold credit protection, and the level of seniority of the purchased credit protection would need to rank pari passu with that of the sold credit protection. In response to commenters’ request for clarity on scenarios where a banking organization has purchased and sold credit protection on overlapping portions of the same reference index or securitization but where the purchased credit protection does not cover the entirety of the portion of the index or securitization on which the banking organization has sold protection, the Agencies state in the preamble that, in such situations, the banking organization is permitted to offset the sold credit protection by the overlapping portion of the purchased credit protection. To illustrate, the Agencies note that if a banking organization has sold credit protection on the 3-7% tranche(s) of an index and purchases credit protection on the 5- 10% tranche(s) of the same index, the banking organization may offset the 5-7% overlapping portion of sold credit protection, assuming all of the other relevant criteria are met. The Agencies also clarify in the preamble that the effective notional principal amounts of sold credit protection that are cleared for clearing member clients through CCPs are not included in a clearing member banking organization’s total leverage exposure. The clearing member banking organization -6- Bank Capital: Supplementary Leverage Ratio September 16, 2014 would include such a derivative transaction, or other similar instrument, related to the sold credit protection in its total leverage exposure in the same manner as other cleared derivative transactions (that is, if the clearing member banking organization guarantees the performance of a clearing member client with respect to a cleared transaction, the clearing member banking organization would treat the exposure to the clearing member client as a derivative contract). Counterparty criteria for repo-style transactions. The Final SLR Rules adopt as proposed the three criteria that, if not met, would require a banking organization to reverse the GAAP offset for repo-style transactions (that is, the option under GAAP to offset the gross values of receivables due from a counterparty under reverse repurchase agreements by the amount of the payments due to the counterparty if certain applicable accounting criteria are met) and, thereby, replace the on-balance sheet assets for the repo-style transactions with the gross value of receivables associated with such transactions in calculating total leverage exposure. Those criteria are: the transactions have the same explicit final settlement date; the right to offset the amount owed to the counterparty with the amount owed by the counterparty is legally enforceable both currently in the normal course of business and in the event of receivership, insolvency, liquidation or similar proceeding; and the counterparties intend to settle net or settle simultaneously, or the transactions are subject to a settlement mechanism that results in the functional equivalent of net settlement such that the cash flows of the transactions are equivalent to a single net amount on the settlement date. To meet the “functional equivalent” requirement, both transactions are settled through the same settlement system, and the settlement arrangements are supported by cash or intraday credit facilities intended to ensure that settlement of both transactions will occur by the end of the business day and the settlement of the underlying securities does not interfere with the net cash settlement. Commenters requested that the third criterion be revised to remove the requirement that “settlement of the underlying securities does not interfere with the net cash settlement,” arguing that the requirement is unclear. The Final SLR Rules retain this language, but the Agencies indicate that, to achieve equivalence, any settlement system used to settle the transactions must not require all securities to have successfully settled before settling any net cash obligations. Furthermore, the settlement system’s procedures must provide that the failure of any single securities transaction in the settlement system should only delay the matching cash leg (payment) or create an obligation to the settlement system, supported by an associated credit facility. The Agencies note that this requirement that settlement of the underlying securities does not interfere with the net cash settlement is not intended to exclude any settlement mechanism (for example, a delivery-versus-payment or other mechanism) if the mechanism meets these functional requirements, and the third criterion would be met if a settlement system’s procedures allow for all of the above. If the failure of the securities leg of a transaction in such a system persists at the end of the settlement period, however, then the Agencies note that this transaction and its matching cash leg must be split out from the netting set and treated gross for purposes of total leverage exposure. -7- Bank Capital: Supplementary Leverage Ratio September 16, 2014 Accounting sales treatment for repo-style transactions. The Final SLR Rules adopt as proposed the requirement that a banking organization add to its total leverage exposure the value of securities it sells under a repo-style transaction if the transaction is treated as a sale for accounting purposes, for so long as the repo-style arrangement is outstanding. In the preamble to the Final SLR Rules, the Agencies clarify that PFE related to a forward agreement associated with a repurchase or securities lending transaction that qualifies for sales treatment under U.S. GAAP may be excluded from total leverage exposure. In addition, the Agencies note that a forward agreement associated with a repurchase or securities lending transaction that qualifies for sales treatment under U.S. GAAP should not be included in total leverage exposure as an off-balance sheet exposure subject to a CCF. Without this clarification, the Agencies note that the replacement cost and PFE associated with the derivative exposure of an associated forward purchase agreement or forward sale agreement, in combination with the value of the security sold may overstate the actual exposure in total leverage exposure of such a repurchase or securities lending transaction that qualifies for sales treatment under U.S. GAAP. Central clearing of derivative transactions. Under the Final SLR Rules, consistent with the Basel III leverage ratio, a clearing member banking organization is not required to include in its total leverage exposure an exposure to the CCP for client-cleared transactions if the clearing member banking organization does not guarantee the performance of the CCP to the clearing member client. However, if a clearing member banking organization does guarantee the performance of the CCP to the clearing member client, then the Final SLR Rules require a clearing member banking organization to include the exposure to the CCP in its total leverage exposure. At a commenter’s request, the Agencies clarify in the Final SLR Rules that a banking organization may exclude from its total leverage exposure the clearing member’s exposure to its clearing member client for a derivative transaction if the clearing member client and the clearing member are affiliates and consolidated on the banking organization’s balance sheet.