Cut the derivatives business some slack
The federal bank regulators have proposed a rule that would place burdensome capital requirements on certain derivative contracts, potentially creating unintended consequences for nonbanks that would pay more to hedge risk.
The problem stems from a new approach that was developed in 2014 by a team of global experts in Basel that would change how banks calculate their exposure to derivatives under post-crisis regulatory capital rules, called the Standardized Approach for Counterparty Credit Risk, or SA-CCR.
Fortunately, U.S. regulators still have time to amend the rule they jointly proposed in October 2018 before they finalize it — which could be any day — to make sure it doesn’t unnecessarily disadvantages domestic companies. It is critical that these changes to SA-CCR are made now to meet the purpose of improving capital standards without inflicting economic collateral damage.
If these needed changes are not made, the current version of the final rule might prompt businesses that use commodities to limit their use of derivative — a key risk management tool — or cause them to raise prices to compensate for the additional costs associated with using those tools.
Similarly, SA-CCR’s treatment of equity positions could potentially weigh on retirees and investors in the U.S. equities market because of its treatment of liquid, well-capitalized markets. The U.S. regulators should take these changes to their foreign peers to be recognized by the global experts in Basel.
Commercial end users, like corn producers or beverage manufacturers, use financial derivatives to lock-in affordable access to the commodities they need to produce their products and hedge their long-term business risks. They often rely on forward contracts to obtain a predictably stable price of the same product years in the future.
However, it appears that in developing the proposal, U.S. regulators imported supervisory risk factors used by the Basel Committee, which rely upon the more volatile spot market — the price of the immediate delivery of a product — when determining risk for commodity contracts.
The proposal also doesn’t take into account that some commodity contracts, such as a gas contract, are settled on a monthly basis. Instead, SA-CCR applies a risk factor to account for an entire year, without accounting for what has already been settled.
To further exacerbate the issue, U.S. regulators have added higher standards, known as gold-plating for energy commodities, creating more unintended consequences. The result is an overstatement of risk in the SA-CCR capital calculation. This means companies that use commodity derivatives to hedge their business risks have to pay more to do so because of their banks’ higher capital requirements.
The agencies should adjust SA-CCR to recognize companies’ employment of the risk-management practices. This could include longer-dated forward contracts, which are less volatile and would more accurately reflect how companies use derivatives to hedge their exposure to swings in commodity prices. That would be a regulatory win-win for agencies and the economy, a policy outcome everyone should want.
One example of why SA-CCR’s use of the spot market to determine commodity risk is misguided can be seen with natural gas markets. During a particularly cold month in winter, the price of natural gas for immediate delivery can spike. Likewise, it may tumble if it’s an unusually warm month.
However, the price for a similarly sized contract, maturing in one or two years, is much less susceptible to such weather-driven swings. Utilities overwhelmingly utilize long-term derivatives to obtain price certainty years into the future. This is why the volatility of these longer-term contracts is a more appropriate measure of the market.
Another example of where SA-CCR misses the mark is its approach to equities. As currently written, SA-CCR assumes a level of price volatility that is nearly double the highest levels experienced during the 2008 financial crisis.
In addition, SA-CCR takes a one-size-fits-all approach to equities. The proposal does not differentiate between investment-grade and non-investment-grade stocks. Nor does it take into account differences between developed markets and emerging markets.
SA-CCR therefore penalizes the U.S. market, which is well-developed, liquid and less volatile compared to an emerging market. The result is U.S. investors in the — often people saving for retirement — would have to pay more because those investments are being labeled riskier than their actual risk.
Regulators should recalibrate SA-CCR to recognize the wide variety in prices presented by such different types of equities and improve risk management.
Taken in its entirety, SA-CCR represents a needed modernization of derivatives regulation. However, the proposal’s changes to the treatment of commodity and equity trades must be addressed to avoid a disproportionate impact on U.S. financial firms.
Without the necessary modifications, SA-CCR will inflict unnecessary and expensive damage to the derivatives markets upon which banks and their business, their customers and the broader economy rely.