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Federal Deposit Insurance Corp. Chairman Martin Gruenberg, discussing progress in establishing big-bank resolution regimes, said the Federal Reserve is developing a rule "to codify" the swaps protocol involving termination rights.
May 12 -
The Financial Stability Boards proposed capital and long-term debt requirements would only go part of the way toward ending the risk of government bailouts. If regulators really want to get rid of too big to fail, they need to deal with over-the-counter derivatives market.
March 4 -
Regulators should demand more derivatives disclosures in forthcoming living wills. Having banks disclose the risk factors in their risk measurement models would help regulators understand if banks are well capitalized for unexpected losses.
March 12 -
Banks and industry groups worry that the Financial Stability Board's "total loss absorbing capacity" proposal could disrupt capital formation while reform advocates say the rules could be strengthened even further.
February 17
Federal Deposit Insurance Corp. Chairman Martin Gruenberg said in
"That was not an option available to us in 2008," he added. "I think it is an option available to us today."
Some observers believe that Gruenbergs view signals an end to the practice of bailing out the creditors of "too big to fail" banks. But in reality, the statement by the head of the U.S. bank insurance fund is more subtle and nuanced in its implications.
Since the 2008 financial crisis, regulators have been wrestling with the question of how to resolve a large failed financial institution without causing a breakdown in the global payments system. The key driver of TBTF has not been the necessity to bail out the bondholders of large banks, but rather the need to avoid disrupting the trillions of dollars of payments and over-the-counter derivatives contracts that move between global financial institutions each day.
As I noted in an American Banker op-ed in March,
The FDIC has been working diligently to address the issue of counterparty risk, most recently by collaborating with the International Swaps and Derivatives Association to
In simple terms, the new ISDA protocols prevents swap counterparties from taking their collateral and running away from a failing bank precisely the scenario that occurred in 2008. Title II of the 2010 Dodd-Frank Act generally imposes a one or two business-day stay on the exercise of default rights, but regulators acknowledge that this interval is far too brief to allow for effective action in the event of a large bank failure.
The ISDA 2014 Resolution Stay Protocol,
The refusal of large investment firms to support the ISDA Resolution Stay Protocol represents a major divergence between regulators and some of the largest institutional investment firms. But thanks to the diligence of Gruenberg and other regulators, the reticence of these buy-side firms is likely to be short-lived. The ISDA protocol, by its terms, anticipates that regulators in various jurisdictions will adopt regulations in the coming years that will prohibit financial institutions from entering into OTC derivatives transactions with counterparties who have not adhered to the terms of the protocol or otherwise agreed to similar terms.
Eventual adoption of the ISDA protocol will go a long way to repairing one of the most ill-advised developments ever seen in the financial world namely, making OTC derivatives and other qualified investment contracts exempt from the automatic stay in bankruptcy. There is no reason why the users of OTC derivatives should be given superior treatment to bond investors in large financial institutions. Yet this is precisely how U.S. law has evolved since the creation of the retrograde bilateral market for OTC derivatives markets in the 1990s. Congress should repeal this special treatment for OTC derivatives and restore a level playing field for all investors in bank obligations.
In addition to repairing the mischief done by the lobbyists for the OTC derivatives markets, regulators need to focus their attention on attempts to curb the Feds emergency lending powers. Under current law, a large bank experiencing liquidity problems would be forced into bankruptcy or a Dodd-Frank resolution, events that would likely trigger a massive run on liquidity similar to that seen in 2008. Some members of Congress want to place even more limits on the Feds ability to lend, an ill-advised initiative that would ensure a future crisis.
Policymakers need to understand that many of the initiatives taken since 2008, including Dodd-Frank, Basel III and other prudential regulations, have cumulatively reduced the liquidity of the financial markets. Increased capital requirements imposed upon nonbank mortgage firms facing the government-sponsored entities and Ginnie Mae, for example, have actually decreased volumes, profits and liquidity in the mortgage markets. By limiting the liquidity of markets and financial institutions, we make the likelihood of systemic events greater and, ironically, endanger the stability of the payments system.
Advocates of limiting the Feds ability to respond to market disruptions should be careful what they wish for. Instead of placing limits on the provision of liquidity in times of market stress, Congress should be looking for ways to avoid turning short-term liquidity problems into major financial crises. If we restore equal treatment for all investors of large banks while enforcing existing rules on the prudent creation of risk, we can avoid the types of market panics seen in 2008 and thus testing the FDICs ability to resolve large financial institutions.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency, where he is responsible for financial institutions and corporate ratings. He is co-author of the new book