BankThink

Kudos to Fed for Targeting Shadow Bank Systemic Risk

On May 3 the Federal Reserve issued a proposed rule that would require global systemically important banks, or GSIBs, in the U.S. to amend their derivatives contracts in ways that will make it easier to resolve them should they fail in the future. The proposal is a very important step in continuing progress toward a post-crisis framework where even the largest banks can be allowed to fail in an orderly way and without risk to taxpayers. Early opposition to this proposal from unusual quarters is a good occasion to study its merits.

The issue underlying the Fed proposal is as technically complicated as it is important. The Fed proposal attempts to deal with a very specific but meaningful source of systemic risk – namely, the ability of counterparties to immediately tear up derivatives contracts when a GSIB fails. This is a cause of concern, as it can create a potentially destabilizing liquidity drain at the bank, spark fire sales of commonly held assets and transmit risk across the financial system. This ability is a special right that is enjoyed by derivatives counterparties under the bankruptcy code. Unlike most other creditors, who are subject to bankruptcy stays, parties to a derivative are permitted to immediately "close out" their positions and seize related collateral when their counterparty fails. Over the years, many derivatives contracts have included so-called cross-default provisions that extend this close-out right even further, such that it can be exercised even when the counterparty remains solvent and continues to perform but an affiliate of that counterparty fails.

These cross-default provisions can be a potential problem in the resolution of a GSIB. The prevailing resolution framework developed by the Federal Deposit Insurance Corp. and other global regulators is the so-called single-point-of-entry, or SPOE, approach. That approach is predicated on the idea that, if a GSIB were to fail, its holding company would be placed into resolution and the long-term creditors of that holding company would be bailed in, having their debt instrument converted into equity. The resulting resources would then be used to recapitalize the bank's key subsidiaries to keep them operating and meeting obligations to all counterparties – thereby minimizing systemic risk.

Permitting derivatives counterparties to invoke cross-default rights and walk away en masse from existing contracts with one of those open, solvent and operating subsidiaries during an SPOE resolution would reintroduce the kind of financial system disorder that the post-crisis bank resolution framework is intended to eliminate. And it would ignore that fact that derivatives counterparties are already well served by the SPOE approach, since keeping that subsidiary solvent and performing on its contracts leaves them no worse off. In many cases they will likely be better off than they would otherwise be.

Recognizing this, the world's largest banks coordinated with regulators and the International Swaps and Derivatives Association to develop a protocol under which those banks voluntarily waived this cross-default right for derivatives deals with one another. The Fed proposal would help complete this process by eliminating this right from large banks' derivatives contracts with all other counterparties. It would do so indirectly, by requiring GSIBs in the U.S. to make the change for derivatives and similar trades with any counterparty with which they continue to transact. That would mean, conversely, that counterparties would either need to accept the change or look to other firms for their derivatives needs going forward. The Fed proposal also provides an alternative option for compliance – adherence to the existing ISDA protocol, which was negotiated with significant buy-side involvement and contains a range of special creditor protections.

In an interesting inversion of the usual scenario, it is parts of the shadow banking system – particularly hedge funds and some fund managers – that have reacted to these proposed banking rules with uproar, expressing concern that the proposal would reshape how they trade derivatives. They have characterized the proposal as an unfair intervention by banking regulators into their contractual rights. But the change they are being asked to embrace seems small fry relative to the benefits of a more resilient financial system.

The Fed deserves significant praise for moving forward with a thoughtful and promising measure to further limit risks to financial stability. With any luck, the increased attention to this proposal may also serve to remind us all that enduring improvements to the resilience of our financial system must reflect all of that system, including the parts that lie outside the banking perimeter. That would be welcome, because as the Fed has recognized here, systemic risk is just that – systemic – and requires solutions that take a broad view of the whole financial system.

Jeremy R. Newell is executive managing director, head of regulatory affairs and general counsel of The Clearing House Association.

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