International Financial Reporting Standards (IFRS) are an appropriate method of accounting for derivatives, especially as it influences the leverage ratio in judging capital adequacy for financial firms. U.S. GAAP allows the fair value of derivative instruments to be carried on the balance sheet on a net basis when a master netting agreement provides the legal right to settle the contracts on a net basis in the event of default, insolvency or bankruptcy of one of the counterparties. IFRS, in contrast, require the fair value of derivatives transactions to be reported on a net basis when, and only when, there is an unconditional right to set-off and the intent to settle on a net basis. This means that for derivatives netting under IFRS, the ability of either party to insist on net settlement must be enforceable at all times, and not just upon the default, insolvency or bankruptcy of one of the counterparties. This distinction is of great practical importance and results in derivatives activities on GAAP balance sheets being reported in much smaller amounts than they would be under IFRS.
For certain exposures, particularly derivatives exposures, the Basel capital accord allows institutions to recognize significant amounts of netting in a manner consistent with U.S. GAAP for purposes of determining capital requirements. This treatment significantly reduces the amount of leverage capital and risk-based capital that is required to be held against these activities. For example, at the end of the first quarter of 2013, the U.S. banking organizations with the five largest derivative portfolios held about $283 trillion in notional value of derivatives. The absolute gross fair value of these instruments is $10.6 trillion. However, for purposes of calculating the existing leverage ratio, capital is held against only approximately $282 billion1 of this amount because of U.S. GAAP netting rules.
One of the more important lessons of the last crisis is that derivatives transactions can be among the most highly leveraged and, therefore, risky transactions engaged in by financial firms. Strong capital requirements are essential to limit incentives on the part of bank managers to gamble with these instruments, putting at risk their institution and the financial system more broadly. Relying on U.S. GAAP's more permissive approach to derivatives netting eliminates the ability to account for the implied economic leverage these instruments present. Leverage not only increases the risk of default, but it also increases the potential for rapid deleveraging, and financial institutions should hold capital against these risks.
Given the importance of having appropriate capital requirements for derivatives, it is worth critically examining the case for regulatory capital recognition of netting of these instruments. The Financial Accounting Standards Board (FASB) argued in its January 2011 proposal to move towards an IFRS approach to netting of derivatives that accounting principles do not support reporting on a net basis when there is not an unconditional right to settle on a net basis. Without an unconditional right of net settlement, it is simply incorrect to say that a bank's derivatives claims or obligations involving the same counterparty are for a single net amount. Its obligations arise under one or more contracts with cash flows that may be sensitive to certain market factors, and its claims arise under other contracts with cash flows sensitive to other market factors. In substance, the bank has liabilities and separate assets. Ultimately, after considering the comments and after a change in member composition of FASB's Board of Directors, it decided to retain the existing offsetting model.
Combining separate derivatives assets and liabilities with the same counterparty into a single net amount when there is no ability to offset on a day-to-day basis ignores economic reality. Allowing netting under a master netting agreement treats all transactions as if they were a single contract, when they clearly present different risks. The pricing of each derivatives contract is independent and can change significantly over time; transactions are negotiated separately; terms and conditions differ; and they can be transferred or settled separately. Our capital requirements should not ignore these differences.
Finally, allowing netting under a master netting agreement is inconsistent with similar situations. We don't net collateral, even cash collateral, or other types of assets or liabilities, even where conditional rights of set off are present, such as nonrecourse debt arrangements and some broker/customer relationships. In those situations, we do not deem offsetting, or netting, appropriate based upon what might happen (i.e., a counterparty defaults), and there is no sound rationale for why regulators should give derivative transactions more favorable treatment than similar economic arrangements.
The rationale for recognition of netting appears to apply most directly to the calculation of risk-based capital requirements for counterparty credit risk, the risk of credit loss arising from the default of a counterparty. With risk-based capital charges for counterparty credit risk, there is at least a conceptual basis for recognition of netting, if the netting can be relied on to work.
Nevertheless, while the risk of netting arrangements not working may appear remote in theory, the example of the Lehman bankruptcy is instructive. In considering different cases, the bankruptcy court in the U.S. held that the non-defaulting counterparty could not indefinitely suspend its payment obligations upon the default of the other counterparty; however, the bankruptcy court in the UK came to a very different determination and upheld the right of the non-defaulting counterparty to suspend its performance indefinitely. Therefore, there is legal ambiguity over whether master netting arrangements will work as intended in future crises, at least in the context of international activities.
The Basel Committee and the regulatory agencies do, of course, have a risk-based capital framework, which some would say addresses the risk of derivatives. This includes the counterparty credit risk charges intended to address the credit risk arising from defaulting counterparties, Basel III's new credit valuation adjustment intended to address the risk of write-downs required as a result of changes in the risk profile of a counterparty, and the Market Risk rules that are intended to address the risk of losses from market volatility. And the Basel III leverage ratio does include a measure of the potential future exposure (PFE) on derivatives in the denominator, which it appears would comprise the bulk of the Basel III leverage capital charge on derivatives. However, I also understand that the Basel Committee is considering changes that would further increase the recognition of netting in the risk-based capital framework. The continued robustness of the PFE charge as part of the Basel Committee's leverage framework will depend in part on whether the Committee decides to allow its computation to reflect additional recognition of netting.
Expanded recognition of netting is a subject of active discussion in the Basel Committee and seems most appropriate within the context of a risk-based approach to capital adequacy. For purposes of a simple, non-risk sensitive regulatory capital metric, however, it is inappropriate to eliminate the exposure arising from multiple derivatives with the same counterparty by netting what are, in economic substance, separate assets and liabilities that elevate the effective leverage of a banking organization.
I continue to judge that when determining leverage-based capital requirements, regulators should not take the GAAP approach to netting for derivative transactions but should pursue something much closer to an IFRS-based approach that allows netting only when the ability and intent to settle on a net basis is unconditional. I am supportive of current efforts on the part of the Basel committee to modify the leverage ratio and limit the circumstances under which netting can be applied to written credit derivatives. However, this effort addresses only one type of instrument, and a more complete and comprehensive solution is needed for all types of derivative transactions.
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Notional amounts and gross fair values are from the March 31, 2013 FR-Y-9c, Schedule HC-L. The $282 billion estimate of derivatives exposure for the current leverage ratio is drawn from the amount of derivative assets reported on the March 31, 2013 10-Q filings. The aggregate amount of derivatives assets reported by these firms was $4.6 trillion before the recognition of $4.1 trillion in counterparty netting and $271.6 billion in cash collateral netting. The exact amount of derivatives exposure in the U.S. leverage ratio is technically a three month average and the derivatives data used in this estimation is available only on a quarter-end basis. It should also be noted that under the proposed Basel III Supplementary Leverage ratio, an estimated additional $852.9 billion in potential future exposure would have been included in the ratio denominator.