Why Simplifying the Counterparty Credit Proposal Is Just So Complicated

WASHINGTON — The Federal Reserve Board is getting an earful from critics on its proposal to limit banks' credit exposures to a single entity, with many saying the agency's process for deciding what counts as an affiliate is too complicated.

But the solutions posed for simplifying that process differ dramatically.

In March, the Fed issued a proposal that would establish single-counterparty credit limits for banks with more than $50 billion in total assets — a statutory requirement laid out in the Dodd-Frank Act. The plan lays out a tiered system under which the largest banks — those considered globally significant financial institutions — face the a 15% of Tier 1 capital with a single counterparty if that counterparty is also considered a GSIB. With other institutions, the limit is 25%.

But the largest banks argue that the plan is overly complex and would cause banks to chase after each of their counterparty exposures to ensure they do not exceed the limit.

"Exposures to most counterparties most of the time will not approach a covered company's credit limit," several large bank trade groups, including The Clearing House, the American Bankers Association, the Financial Services Roundtable and the Financial Services Forum, wrote in a joint letter. "Covered companies should be devoting their resources to identifying and monitoring those that do, rather than continuously tracking down remote connections among counterparties to which the covered company has de minimis exposure, and about which the covered company has limited information to analyze. Many of our recommendations are designed to simplify the re-proposal."

One large issue is how the plan defines affiliates. The plan employs the definition under the Bank Holding Company Act, but industry lobbyists argue it should use the one employed by generally accepted accounting principles, or GAAP.

In short, the BHC definition is broader and encompasses more firms than the GAAP method, which makes exceptions for entities like nonprofit organizations, nonbusinesses, benefit plans, government organizations and certain investment companies. The GAAP model also takes into account what it terms "variable interest" –whether the fortunes of the firms rise and fall together or not — as a means of whether firms are affiliates.

The joint letter notes that the GAAP method is the standard used by the Fed elsewhere in its regulatory structure, including for calculating regulatory capital levels. Adopting an overly broad definition when another one is already in place elsewhere is needlessly complex, the letter said.

"The BHC Act control definition, which is exceedingly broad and focused more on the powers-related and structural limitations of the BHC Act and not on economic risk, would impute to covered companies the exposures of a wide range of entities that pose no meaningful risk of loss to the covered company," the letter said.

Tom Quaadman, senior vice president of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, echoed those concerns by criticizing the expansive definition of company control. The Fed may put businesses in a position where they lack access to financing, he warned.

"Without significant simplification, we fear the proposed rule will make it cost-prohibitive for affected financial institutions to continue servicing many of their clients, leaving small and medium-sized businesses with less access to lenders and potentially affecting the already fragile health of our securitization markets," Quaadman said.

Dennis Kelleher, president of the public advocacy group Better Markets, agreed that the proposal was unnecessarily complicated in its determination of which entities would count as affiliates for the purposes of calculating total exposures. But the problem was that the Fed did not take into consideration the fact that some off-balance-sheet exposures can be just as potent as on-balance-sheet credit relationships in times of stress, he said.

"While this formulation looks past legal form, it unfortunately defines 'economically interdependent' using a multitude of factors that will be difficult to objectively evaluate," Kelleher said. "Given that in a time of crisis a counterparty will seek to protect its affiliates, a more effective way of mitigating counterparty credit risk would be to simply require a holding company to calculate its exposure to a counterparty by aggregating all of its exposures to the counterparty and its affiliates."

Kelleher similarly argued that swaps and derivatives should not be taken into account as mitigating factors when calculating exposures due to a single counterparty, citing the waterfall of calls on credit default swaps that firms like Lehman Brothers and American International Group faced when the mortgage market collapsed in 2008 as evidence that those instruments do little to actually stem

"As the financial crisis demonstrated … in times of systemwide stress, these kinds of guarantees and derivatives propagated systemic rather than contained it," Kelleher said. "By allowing BHCs to calculate their single-counterparty credit limits using aggregate rather than gross exposure, the proposed rule increases systemic risk by encouraging BHCs to rely on the kind of financial engineering that has proven to be dangerously fragile just when it is needed the most."

The advocacy group Public Citizen agreed, calling for any final version of the rule to count credit default swaps — which undermine "the basic relationship between a creditor and borrower" — as part of counterparties' credit exposure to one another rather than as an offsetting position. Further, the group called for the largest banks' single-counterparty credit limit to be reduced even further beyond the proposed 15% limit to 5% of Tier 1 capital.

"For JPMorgan this would permit a $10 billion loan to a real economy firm, which is certainly sufficient for today's largest companies, especially when this $10 billion joins a syndicate with other large lenders," the letter reads. "This 5% limit would mean that 20 JPMorgan client firms with loans of this size would need to declare bankruptcy for the bank to reach insolvency."