New proposals from the supervisory authorities with serious consequences
Source: KPMG Corporate Treasury News, Edition 46, August 2015
Basel III: Own funds requirements for CVA risk
The proposals published by the Basel Committee on Banking Supervision (BCBS) and ESMA in July and August on own funds requirements for derivatives trading by banks and determining the clearing obligation under EMIR may also have serious consequences for corporate hedging strategies. In both cases, it is proposed that the exception for derivatives entered into for hedging purposes be eliminated. This may increase hedging costs or, for companies that perform large-scale derivatives trading, trigger the clearing obligation.
In February 2015, the European Banking Authority (EBA) published its recommendations to the European Commission on the revision of own funds requirements for credit valuation adjustment (CVA) risk for derivatives. The BCBS subsequently published a consultative document on this matter on 1 July 2015. The key aspects of the BCBS proposals include methodological changes (integration of own funds requirements for CVA risks into the market price risk framework, alignment of regulatory CVA risk with CVA under commercial law) as well as the inclusion of all derivatives with the exception of derivatives entered into with central clearing counterparties (CCPs).
In contrast to the current status of implementation of the BCBS requirements in the EU (Capital Requirements Regulation – CRR), this means that hedges entered into by industrial and commercial enterprises would no longer be excluded from the own funds requirements for banks. Irrespective of the status of the counterparty, banks would have to calculate the risk that the fair value of a derivative will be negative from the company’s perspective during its term, i.e. that it will constitute a liability for the company, and hence that the company’s credit risk will become an element of the fair value. The bank would then have to back this CVA risk with liable capital.
If the bank passes the resulting cost of capital on to the counterparty, this will result in increased hedging costs for the latter. To prevent an adverse effect on the real economy, the existing EU regulation on the implementation of the requirements of Basel III provides for an exception for derivatives that are demonstrably used by industrial and commercial enterprises for hedging purposes. This exception could now be eliminated if the EBA and BCBS proposals are included in EU regulation.
EMIR: Calculating the thresholds for the clearing obligation
As part of the responses to the European Commission’s consultation paper on the review of the regulation set out in Art. 85 EMIR, ESMA proposed an extensive change to the regulation on the clearing obligation on 13 August. Under this proposal, derivatives entered into for hedging purposes would no longer be excluded when calculating the thresholds for the clearing obligation. Instead, all derivatives within a given asset class (especially commodities, currencies and interest rates) would be viewed in relation to newly defined thresholds irrespective of their purpose. These thresholds would be determined on the basis of the systemic relevance for this class of derivatives.
One potential consequence may be that it becomes easier to demonstrate that a company is not subject to the clearing obligation as an NFC because it is no longer necessary to provide evidence of a hedging purpose. At the same time, however, companies with relatively large derivative volumes in a given asset class can be expected to be subject to the clearing obligation even if they only enter into economic hedges for the purposes of their operating business.
Both proposals remain at the discussion stage and have not yet been enacted in legislation, but their importance should not be underestimated in light of the EU institutions, EBA and ESMA, from which they originate. At the same time, the proposals both illustrate the fact that financial market regulation is still subject to permanent change, and companies operating in the real economy must come to terms with this. One potential consequence is the need to further develop the valuation methodology for derivatives in order to examine whether conditions are consistent with the market and to weigh up the liquidity costs of hedging against the costs of unsecured derivatives. Another potential outcome is that companies will reconsider their entire hedging strategy in terms of the cost/benefit ratio, become increasingly flexible with regard to their hedging decisions and increasingly make use of option strategies.
Author: Prof. Dr. Christian Debus, Partner, email@example.com
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