I have been reading through the Basel Committee of Banking Supervisors’ (BCBS) Consultative Document of 5 November 2015 on Haircut Floors for Non-Centrally Cleared Securities Financing Transactions. This sets out the proposed incorporation into Basel III of the recommendations of Workstream 5 of the Financial Stability Board (FSB) on securities financing transactions. In particular, the paper sets out the framework for minimum haircuts to be imposed on non-centrally cleared SFT between banks and non-banks. If transactions do not meet these minimum haircuts, they will be considered uncollateralised for the purposes of capital adequacy calculations. The methodology of the proposals is problematic.
The first problem is that the measure of haircut used by the BCBS is not a haircut at all. A haircut is a discount of the cash value of an SFT to the value of collateral, ie the ratio of (1) the difference between the value of the collateral and cash to (2) the value of the collateral. The BCBS “haircut” is, in fact, a bastardised version of an initial margin. An initial margin is a premium in the value of collateral over the value of cash, ie the ratio of the value of collateral to the value of cash. For example, the BCBS/FSB “haircut” of 6% is actually an initial margin of 106%. The true equivalent haircut would be 5.66% (= (106-100)/106).
While the BCBS are being consistent with the way haircuts are expressed in Basel III for adjustments to collateral and exposure values for capital adequacy calculations, it is confusing to use the word “haircut” in regulations that are supposed to be applied at market level. This criticism may seem semantic but it is worth recalling the problems that the confusion between haircut and initial margin caused with term repo just before GMRA 2011. It would also be a good idea to ensure the BCBS terminology was consistent with the reporting requirements of the EU SFT Regulation (SFTR).
The second problem with the BCBS haircut framework is the method calculation of haircuts for individual SFT within a “netting set” (ie a portfolio of SFT under the same master agreement), at least as set out in the example on p6 of the BCBS paper. Each SFT with cash in the same cash currency or the same type of security against the same type of collateral (where the typology is that of Basel III supervisory haircuts) is given a representative “artificial traded haircut” according to the formula:
where Ci is the sum of the collateral Sj (which can be cash in the same currency or the same type of security) and Ei is the sum of the exposures created by lending the same currency or same type of security Sk. The artificial traded haircut is represented by Hj,k. This means it is a haircut to be applied to Sj when it is collateralising an exposure to a loan of Sk. The artificial traded haircut has to be compared with the floor as shown in the table below or as implied by the following formula: