Buried in the pages of legislation recently proposed to reform regulation of derivatives activity in the U.S. lies a major threat to the safety and prosperity of the financial services industry.

The new legislation would give the Federal Deposit Insurance Corp. the power to ignore certain parts of privately negotiated contracts governing derivatives transactions in the event of a bank failure.

This would increase uncertainty among market participants, arbitrarily shift the costs of a bank failure from the FDIC to the counterparties of the failing bank, and hamper institutions in their risk management efforts.

In addition, by exacerbating existing uncertainty following a bank failure, the legislation also could add to the systemic risks it purports to mitigate.

Act's Requirements

A derivatives transaction is a bilateral transaction negotiated between two counterparties that derives its value from some underlying asset, reference rate, or index. Popular types include interest rate swaps, commodity options, and currency forward contracts.

The proposed "Derivatives Safety and Soundness Supervision Act of 1994," introduced on May 26 by Rep. James Leach, Rlowa, and Rep. Henry Gonzalez, D-Tex., requires banking regulators to develop principles and regulations regarding capital, suitability, reporting and disclosure, and accounting for banks engaged in derivatives activities.

In addition, the legislation would alter the current treatment of derivatives under banking insolvency law.

The Federal Deposit Insurance Corporation Improvement Act of 1991 mandates that the FDIC as "receiver" of a failed depository institution resolve that institution at the lowest possible cost to its insurance fund. The FDIC therefore must resolve derivatives contracts in a failed institution in the cheapest of several ways.

Contract Resolution

First, the FDIC may "repudiate" or terminate "burdensome" contracts or contracts on which the failed institution owes money, leaving counterparties to share proportionately with other general creditors the cash raised in selling the assets of the failed institution.

Second, the FDIC may transfer all of the contracts between a single counterparty and the failed institution to another depository institution, thus leaving those contracts in force.

Standardized contracts, or "master agreements," govern most derivatives transactions. For example, the master agreements of the International Swaps and Derivatives Association are the most frequently used form of documentation by more than 70% of all swaps dealers, according to a 1993 survey by Price Waterhouse for the Group of Thirty.

The ISDA master agreements specify "events of default," such as the appointment of a receiver, which allow the nondefaulting counterparty to terminate a derivatives contract upon their occurrence.

In addition, the ISDA master agreements require the consent of a counterparty for any transfer of the contract to another institution.

'Grace Period'

Notwithstanding the above, the FDIC issued a policy statement in 1989 that curtails a counterparty's right to terminate a contract subsequent to a bank failure, as long as the FDIC has notified the counterparty by the close of business on the day after its appointment as receiver that it has transferred all of the counterparty's derivatives and related contracts to another depository institution of the FDIC's choosing.

This "grace period" appeared in early drafts of the Financial Institutions Reform, Recovery, and Improvement of 1989, but due to an apparent drafting error, the language was dropped from the final legislation. Although the FDIC's policy statement has never been challenged, it has no statutory force behind it at present.

The proposed act would cure this drafting error by amending federal banking law and codifying the one-day grace period, giving rise to four problems.

Source of Conflict

First, the legislation would create a conflict with another, related statute concerning counterparties' rights to terminate their derivatives contracts with a failed banking institution.

The conflict stems from a provision of banking law codified by the FDIC Improvement Act. Specifically, if derivatives contracts are "netting contracts" (e.g., the ISDA master agreements) negotiated between two "financial institutions," the provision guarantees counterparties the right to terminate their contracts upon the appointment of a receiver.

(A "financial institution" is defined in the improvement act and Federal Reserve Regulation EE, and it includes depository institutions, investment banks, and other active participants in derivatives activity.)

Since the proposed legislation does not clearly alter the statute codified by the improvement act, these counterparty termination rights would be muddied by the legislation enactment. A bank failure then would be followed by a period of significant uncertainty as counterparties and the FDIC haggle over statutory interpretation and whether contracts can or cannot be terminated.

Second, if the does give discretion to the FDIC to refuse termination notices, the grace period could force parties to repudiate contracts to bear additional costs of a bank failure.

Because the FDIC can take a full day to repudiate derivatives contracts, those contracts could incur losses due to adverse market movements during that day.

Hedging Hampered

The FDIC must compensate parties to the failed bank for additional day of adverse price movements. However, that compensation may be treated along with the derivatives contract as a general unsecured claim on the assets of the failed institution.

"Depositor preference" legislation enacted in 1993 requires that such claims be paid off only after all the uninsured and insured depositors are paid.

So, any adverse price movements during the FDIC's grace period likely will result in a partial - if any - payment to counteparties, especially if the failed bank has significant deposit liabilities relative to its remaining assets. During a period of significant market volatility, that additional cost could be significant.

Third, a nondefaulting institution will not know for 24 hours whether its contract will be repudiated or transferred.

Consequently, the solvent institution's ability to hedge against market risk will be hampered. Solvent counterparties using derivatives to hedge would have to decide whether or not to replace their possibly-repudiated contracts.

Guesswork Required

If a contract with the failed bank is replaced with a new contract and the FDIC transfers the original contract 24 hours later, the counterparty will be over-hedged. By contrast, failing to replace a contract that is repudiated by the FDIC 24 hours later would leave a counterparty underhedged over that period.

The resulting guesswork required of counterparties to the failed bank will make it nearly impossible for them to hedge on the day following a bank failure.

Finally, the grace period may exacerbate credit risk for some counterparties to the failed institution. The grace period would allow the FDIC to transfer derivatives contracts to an institution of its choosing without obtaining permission of the counterparties.

Credit Limit Overages

If contracts are transferred to an institution that does not meet the approval of the solvent counterparties, the latter may be forced to assume counterparty credit risk which they otherwise would have avoided.

Even if the new institution is creditworthy, the parties to the failed bank may already be at their own maximum credit limits with the new institution. So, FDIC transfers could force parties to the failed institution to incur credit limit overages - an activity on which banking regulators usually frown.

Without a grace period for the FDIC, the termination provisions of the original derivatives contracts would stand in the event of a counterparty default. Market participants know this when they sign the contracts.

Not only have they agreed to bear the risk of a default, but the specific terms of the contracts enable institutions to come up with their own ways of managing that risk before the fact. It can be argued that this actually reduces the likelihood that a major default would have system-wide implications, since derivatives participants can develop appropriate contingency plans to deal with known risks.

By contrast, the proposed grace period for the FDIC is a high-handed embodiment of arbitrary and uncertain regulation, and arbitrariness is one risk against which financial institutions cannot hedge.

By adding to uncertainty at the time of a bank failure, the proposed legislation could create the very risks to the financial system which it was drafted to help mitigate.

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