I am pleased to be asked to be able to publish this excellent article by Thomas Aubrey (thanks to Con Keating for intermediation).

I’m not sure why this has not been picked up in the mainstream financial press. I hope it will spark interest, as private credit makes up a large part of many DB and (increasingly) DC funds. 

Thomas is a Corporate business advisor, macro-credit specialist and founder Credit Capital Advisory. 

The UK pension fund sector will experience rising costs when transacting with banks as a result of the Basel III reforms. To address this cost issue will require pension funds to engage with their global banking partners and develop appropriate solutions. While none of the proposed solutions are quick to implement, if pension funds make this a priority in 2024 there is sufficient time to put solutions in place prior to implementation in 2025.

Basel

Following the global financial crisis, the standards for the prudential regulation of banks underwent a process of reform aimed at addressing the shortcomings identified in the previous Basel II framework. The final components of the Basel III Endgame were concluded in 2017 which included introducing rules to minimise the variability of risk weighted assets (RWA) between banks via an ‘output floor’. This will require the RWA of banks using internal models to not be lower than 72.5% of the RWA calculated under the standardised framework.

Overall, the new body of measures has increased the resilience of the banking system which is critical for financial stability and economic growth. However, the Basel III accord has also created some unintended, but material negative impacts for UK pension funds when transacting with banks.

Pension funds interact with regulated banking organisations for a number of critical services including areas such as interest rate and foreign exchange hedging, clearing, as well as securities finance transactions and repo. When a fund transacts with a bank, the bank is required to assess the creditworthiness of the fund which generates an appropriate risk weight to calculate regulatory capital.

To date, much of the activity between pension funds and banks has been carried out by larger internal-rating based (IRB) banks, who have been utilising their internal models to assess the creditworthiness of pension funds. Due to the limited default experience, the risk weights of pension funds are low, typically between 5% – 15%. For comparison, an OECD sovereign has a 0% risk weight under the standardised approach and a risky corporate borrower below a BB- rating, would have 150%. This follows the principle that capital ought to be aligned with risk.

Once the output floor is introduced, it will negatively impact UK pension funds for two reasons. First,  thousands of DC and DB pension funds do not seek an external credit rating since they do not issue debt, which is the main use-case for buying a rating. In addition, the cost of retaining a traditional credit rating agency for a fund is high, which is why fewer than 0.5% of these counterparties have a rating today. Second, under the standardised approach unrated counterparties are assigned 100% risk weight. Although banks that maintain IRB models can apply a 72.5% factor through the output floor, the jump in risk weights from around 12.5% today, to 72.5% is substantial.

The Prudential Regulation Authority (PRA) is aware of the issue of high quality unrated counterparts and has offered banks the option of applying a slightly more risk sensitive approach permitting 65% risk weights for investment grade names and 135% for non-investment grade counterparties. The regulations, however, do not permit banks to pick and choose the approach for each asset class. Hence, depending on the credit quality of a bank’s portfolio, it is plausible that some banks may choose to allocate 100% to unrated counterparties to optimise regulatory capital rather than using the more risk sensitive approach.

Furthermore, the PRA has raised concerns on bank assessments of the credit risk of funds – particularly given the recent experience of pension funds using a liability driven investment approach. In their recent letter to Chief Risk Officers, the PRA has requested banks to improve their risk assessment of funds in the light of the turbulence in Autumn 2022, driven by excessive leverage via derivatives.

Increased Costs

To illustrate the dramatic increase in costs for a transaction between a pension fund and a bank, Table 1 compares the implied cost in the pre and post Basel III Endgame worlds. It is assumed that banks allocate the capital requirements to that business activity, and then pass on the cost of the capital associated with this additional RWA to their counterparties.

Based on the below assumptions, the current implied cost of equity capital is around 4bps for a typical transaction with a fund, which will rise to 23 bps post-implementation assuming the unrated 100% risk weight is used. If a bank decides to use a more risk sensitive approach for its entire portfolio and the fund is investment grade, the cost would be 15 bps. But if the fund is highly leveraged through a derivatives strategy, it may not be considered investment grade and will see its cost jump to 31 bps.

Table 1: Implied Banking Cost

This dramatic jump in the cost of capital will impact pension funds, as in order to maintain the required return on equity, a bank would increase the cost charged to its clients. Alternatively, the bank may decide to exit a capital markets business, given there may be alternative opportunities for banks to deploy their capital.

While the above analysis is assessed at the transaction level, the output floor is implemented at the portfolio level. Furthermore, in practice, some banks may absorb a portion of the higher transaction costs depending on the overall value a relationship with a fund brings to the bank. However, it is clear that higher costs are coming to UK pension funds, which in turn will reduce returns to savers and the future level of consumption as those savers retire.

Solutions

The PRA has timetabled the start of the transition of the output floor to start in 2025. While that might seem a long way off, none of the proposed solutions to the problem are quick to implement, while some are more straight forward than others. These include:

CCP: Utilising a central counterparty clearing house requires parties to become members of the CCP which has both initial costs as well as ongoing fees, although it can reduce the risk weight of the counterparty to 2%. In addition, CCPs tend to focus more on standardised types of transactions in certain geographies which is likely to require multiple CCPs for standardised transactions.

Credit ratings: Funds have traditionally chosen not to request ratings due to their cost and the fact that funds mostly do not raise money on the capital market.

Capital markets transactions: Capital market transactions can potentially reduce exposure through significant risk transfer. However, these types of transactions are not typically accessible to the vast majority of funds due to the level of complexity and are not scalable.

Pledge: Pledge is only applicable to securities lending which allows borrowers of securities to transfer collateral to lenders by way of security interest rather than an absolute transfer of title. This is not permitted for certain types of funds including UCITS, and is also not accepted by regulators in certain jurisdictions such as the United States.

While all of the solutions discussed have advantages and disadvantages, it is critical that UK pension funds make this a priority for 2024 and engage with their global banking partners to understand which of the potential solutions could be mutually agreeable to minimise costs. This will ensure that UK pension funds are prepared for the implementation in 2025, thereby avoiding a substantial increase in costs for funds and lower returns for savers.

More on Thomas Aubrey

Thomas Aubrey is the founder of Credit Capital Advisory. He has written widely on financial and economic issues including Profiting from Monetary Policy (2012) and co-authored Prediction Markets: The end of the regulatory state? (2007) with Professor Frank Vibert. He has also acted as a senior policy advisor for a number of British, European and Asian public bodies on areas including capital markets, corporate governance, housing and industrial strategy.

You can read more of Thomas’ writing at Cambridge University’s Bennett Institute