To view the digital version of this report, please click here.
German development bank KfW has established itself as a global capital markets behemoth, in the process acquiring a reputation as an innovative bond issuer, raising €70bn–€80bn of annual funding from Europe, the US and Asia. However, as regulators have sought to bring transparency and security to the over-the-counter derivative markets in the aftermath of the financial crisis, KfW’s extensive usage of swaps has moved into the spotlight, and raised some thorny issues for the agency and its banking counterparties.
Of particular concern has been the prospect of regulatory mismatches between the US and Europe, which threaten to derail KfW’s established roster of banking relationships. KfW issues the biggest portion of its paper in euros and dollars, which account for roughly 80% of its funding. The remaining 20% is issued in other currencies, like offshore renminbi, in which it is the largest non-Asian SSA issuer. The agency generally converts proceeds from foreign currency bonds into euros, the core currency of its lending business. It also hedges foreign currency and interest rate risk.
The system has worked well, with banks in national jurisdictions always happy to provide KfW with swap facilities following local currency issuance. However, in a recent rule change to European Capital Requirements Regulations policy makers granted banks an exemption to the need to hold capital against KfW counterparty risk, and so handed European banks a distinct advantage.
“KfW is a heavy user in particular of cross-currency swaps for its non-euro funding, and the exemption for banks regulated in Europe from holding capital against those swaps is a key advantage,” said Alex Caridia, a director in debt capital markets at Royal Bank of Canada. “It will make the cross-currency business much cheaper for them.”
As KfW wrestles with the potential impact of the rule change on its swap counterparty relationships a related issue in the derivatives business is collateral, and the use of credit support annexes. Traditionally, agencies such as KfW, which has an explicit state guarantee, have not posted collateral on their derivatives trades. Since the financial crisis, however, they have come under pressure to do so. While some, such as the European Investment Bank have refused to countenance collateral payments, KfW has been more circumspect, and is reported to be willing to post some collateral in the form of its own bonds to its swaps counterparties.
The situation is still far from ideal for dealers, though, with the contracts still heavily weighted in KfW’s favour. The mark-to-market thresholds beyond which KfW has to begin posting collateral against its swaps is understood to be much higher than the level at which its dealer counterparties begin to see margin fly out the door, undermining the benefit of the arrangement for banks. And while dealers may be able to repo KfW paper to lessen the funding burden that accompanies long-dated swaps, receiving these bonds as collateral will do nothing to diminish their counterparty credit risk exposure to the agency.
The issue is emotive among bankers, which all post collateral to agencies, and some said they would stop doing business with SSA clients unless two-way CSAs are implemented in full. Bar the extreme example of UBS pulling out of the business, these threats have proved idle so far. KfW for its part declines to discuss its policies.
The issue of collateral is important for public sector entities like KfW because they are exempt from clearing in both the US and Europe – which requires daily margin posting against swaps positions as well as an upfront initial margin payment – and are hopeful of escaping the regulatory mandate that has caught a large part of the swaps market. KfW has recently approached the Commodities Futures Trading Commission, and has written to the European Commission to pursue a further exemption from margin requirements for uncleared swaps.
Meanwhile, Chancellor Angela Merkel’s coalition said in April it planned to boost oversight of KfW Group’s growth, after its success moved it into Germany’s number three position by assets.
KfW had assets of €511bn in 2012 and is big enough to require supervision by BaFin regulator and the Bundesbank, Klaus-Peter Flosbach, a finance spokesman for the Christian Democrats, said. Meanwhile, SSA bond issuance has fallen sharply in Q1 2013, compared with the same period in 2012 as capital markets normalise following the extreme volatility seen over the past two years. Still, KfW has sold about €30bn of paper, with a recent €5bn US dollar bond printing at a record low coupon of 0.5%, and drawing investors from Asia, Europe and the US.
With the funding machine running like clockwork, it is likely to be regulatory rather than business matters which preoccupy KfW in the weeks and months ahead.