The Federal Reserve Board’s market risk capital rule (MRR) sets forth the capital requirements for banking organizations with substantial trading activities. The MRR rule requires banks to adjust their capital requirements based on the market risks of their trading positions. The rule applies to banks worldwide with total trading activity of more than 10% of total assets or banks with assets in excess of $1 billion. Substantial revisions to the MRR were enacted by the Federal Reserve Board in January 2015. These changes aligned the MRR with the requirements of the Basel III capital framework.
Basel III is a set of international banking regulations designed to help the stability of the international banking system. The main purpose of Basel III is to prevent banks from taking on excess risk that could impact the international economy. Basel III was enacted in the wake of the 2008 financial crisis.
Basel III requires banks to hold more capital against their assets, which in turn reduces their balance sheets and limits the amount of leverage banks can use. The regulations increase minimum equity levels from 2% of assets to 4.5% with an additional buffer of 2.5%, for a total buffer of 7%.
Federal Regulation H
Regulation H of the Federal Regulations spells out the specifics of the MRR. This regulation sets limits on certain types of investments and requirements on various classes of loans. It further presents a new method for calculating risk-weighted assets in accordance with MRR. This new approach increases the risk sensitivity of the capital requirements.
Regulation H also requires the use of creditworthiness measures other than the commonly used credit risk ratings. The revised credit standards apply to sovereign debt, public sector entities, depository institutions and securitization exposure, and seek to create a sound risk structure for those types of exposures. Banks relying on inaccurate credit ratings for derivatives to measure risk was a major factor in the 2008 financial crisis. (For related reading, see "The 2007-08 Crisis in Review.")
Regulation H further provides more favorable capital treatment for credit swaps and other derivative trades cleared through centralized swap execution facilities. This incentive encourages banks to use centralized clearing as opposed to traditional over-the-counter trading. Centralized clearing can reduce the possibility of counterparty risk, while increasing the overall transparency of the swaps trading market.
Swap Agreements and Counterparties
Swap execution facilities shift derivative trading away from the traditional over-the-counter markets to a centralized exchange. In centralized clearing, the exchange is essentially the counterparty to a swap trade. If a counterparty to a swap agreement fails, the exchange steps in to guarantee the agreement with no default. This limits the economic repercussions of a counterparty failure. American International Group (AIG) defaulted as a counterparty for many swap agreements, which was another major cause of the 2008 financial crisis. AIG needed a massive government bailout to avoid going under. This highlighted the need to create centralized clearing for swap trades.
Dodd-Frank also impacted the MRR. The Collins Amendment of Dodd-Frank established minimum risk-based capital and leverage requirements for federally insured depository institutions, their holding companies and non-bank financial institutions supervised by the Federal Reserve. Similar to Regulation H, Dodd-Frank also required the removal of any reference to external credit ratings and the replacement of them with appropriate creditworthiness standards.
(For related reading, see "What Is the Minimum Capital Adequacy Ratio That Must Be Attained Under Basel III?")