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June 18, 2018

BoE published a working paper that examines the impact of the leverage ratio on client clearing. This paper assesses the relative importance and interaction of capital requirements and "margining" in over-the-counter (OTC) derivative markets.

As part of the post-crisis regulatory reform, many interest-rate derivative transactions are required to be centrally cleared. The treatment of this type of transaction under the leverage ratio requirement does not allow for the use of initial margin to reduce the exposure, thus increasing capital costs. Consequently, the leverage-ratio-affected clearing member banks may be more reluctant to provide central clearing services to clients given this additional cost. This in turn can prevent some real economy firms from hedging their risks. The paper analyzes whether this is the case by exploiting detailed confidential transaction- and portfolio-level data as well as the introduction and posterior tightening of the leverage ratio in the UK in a diff-in-diff framework.

The results suggest that the leverage ratio had a dis-incentivizing effect on client clearing, both in terms of daily transactions as well as the number of clients; however, this impact seems to be driven by a reduced willingness to take on new clients. Faced with higher capital charges, clearing member banks could drop some of their smaller clients because they do not generate the same level of profit as larger ones. These clients in turn may then temporarily lose access to the derivative market, precluding them from hedging part of their risks. Overall, this reduced availability of clearing services may run counter to the globally endorsed goal of promoting clearing to address systemic risk.

The results found in this paper are consistent with the claims that the leverage ratio might increase the cost of providing clearing services in the OTC derivatives market, pushing some clearing members to reduce these services. However, the magnitudes of this reduction are not extremely big, with reductions of the number of transactions and clients of about 5%—and mostly when the UK leverage ratio was introduced rather than in its posterior tightening. Therefore, the study documents a potentially unintended consequence of the leverage ratio and considers that if the leverage ratio, as it is, is delivering net social benefits, adding the costs found in this paper will probably not alter this conclusion.

Related Link: Working Paper

Keywords: Europe, UK, Banking, Leverage Ratio, Client Clearing, OTC Derivatives, BoE

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