The rocky road to capital release through bilateral netting

Banks and financial institutions enter a multitude of simultaneous financial transactions with each other and their customers. The payables/ receivables arising from them should logically be allowed to be netted. However, ambiguous prior legislations and regulatory interpretations mean that these obligations would not be netted. These invariably inflate capital requirements under the assumption that, in case of a default, the payables would be paid, while the receivables would be paid basis seniority.

This ambiguity was removed with the Bilateral Netting for Qualified Financial Contracts Act, 2020, with which the Government estimated a projected capital release of INR 45,956 crore. The RBI issued guidelines intimating qualified financial instruments and revisions to capital charge, provisioning and NSFR requirements. While this move should have helped banks immediately release capital, this has not happened.

Most banks are yet to implement these RBI requirements, as they struggle with the interpretation, reviewing current agreements, reporting formats and inability of systems to adapt to these computation methods. This, coupled with impending BASEL IV guidelines, primarily SA-CCR, that amends computations, further means that the road to capital release may be a long one.

The senior management of banks has only now begun to understand the implications and associated capital benefits. Most banks had tasked these to their market risk teams, who believed that they had implemented the guidelines without actually enabling the bank to benefit from it. For a smooth transition, banks need stronger governance with involvement of legal, risk, finance, and treasury to cover regulatory scenarios in an irreproachable manner.

The introduction of this legal framework supports banks in many ways including:

Reduction of counterparty credit risk and regulatory capital

Improvement in provision coverage ratio and reduction in provisions for standard derivative assets

Alignment of the exposure definition across regulatory and financial reporting

Reduction in hedging costs on derivatives

Enables close-out netting arrangements between offshore business units, branches, and subsidiaries of foreign banks with home regulations

While the laws and regulations have been projected as major and progressive reforms in the OTC derivatives market, banks continue to struggle with its implementation due to:

Legal complexity related to counterparties and contracts such as:

Evaluating existing ISDA agreements for netting clauses

Treatment for netting between GMRA vs ISDA

Evaluating netting of CCIL exposures

Evaluating permissibility for cross product netting

Need to sign additional agreements with counterparties

Complexity in exposure computation:

Deciding netting sets across exposure categories

Changes in replacement cost (“RC”) and potential future exposure (“PFE”)

Can different currencies be included in cross product netting?

Treatment where no agreement exists

Regulatory/financial reporting formats:

Utilize existing formats or wait for new ones?

Revise the computation methodology post format changes?

Alignment with the new law and regulations is inevitable. To make this transition beneficial, banks need to ensure the following:

Understanding impact areas and exposure definitions.

Banks are now required to identify the netting sets (i.e., group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement). The netting set can include different asset classes, legal agreements and currencies depending on individual agreements and available terms.

These netting sets impact the exposure computation across different finance and risk computations as well as exposures reported in financial and regulatory reports including ALE, RAQ, CRILC, and LEF formats.

Operationalizing bilateral netting correctly

Evaluate agreements with counterparties to identify applicability based on agreement type, their existence, multiple agreements, and jurisdictions. Where not applicable, it may require renegotiation. This requires legal and treasury teams to identify, manage and negotiate quickly.

Convert counterparties into netting sets incorporating the RBI guidelines for capital, NSFR and leverage computations. This becomes an ongoing process as new agreements are signed (including with its own offshore units or parent entity).

Understand calculation scenarios for netting sets across RC, PFE, NGR and exposure computations as well as in case of repos and reverse-repos.

Computation of impact on capital and other ratios will require application on the portfolio at a netting set level to impute the revised exposure, capital, and provision numbers to understand the benefits, and identify system changes for automating the computations.

Revise the regulatory/ financial reporting framework to incorporate the impact on data definitions for reporting, aggregation, and segregation logics.

Looking Beyond the near term

Bilateral netting is a significant reform that helps banks in obtaining benefits of regulatory capital reduction and sets a mechanism for close-out netting that improves financial stability. There are significant other reforms in the pipeline that will enable transparency and reduction of systemic risk in financial transactions especially in OTC derivative markets. While impending guidelines on variation margin and on credit derivatives come-out, implementation of bilateral netting becomes a foundational pre-cursor to reducing systemic and organization specific risk in the OTC derivative markets.

The author is executive director, Acies

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