WASHINGTON — Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig pushed back Wednesday against recent calls to ease the capital treatment of certain derivatives transactions.
Some have criticized the impact of the "leverage ratio" — the strongest measure used by regulators to assess capital adequacy — on cleared derivatives. In such deals, participants post margin, but critics charge the collateral, which they say is designed to cover loss, can force higher capital requirements since the bank reports it as an asset.
But Hoenig, who expressed concern that the industry's wishes "are being taken seriously by some regulators," argued that any move to provide more favorable treatment for derivatives would undermine efforts to strengthen capital levels following the crisis.
"Weakening derivatives capital requirements would encourage even larger volumes of interlinked and opaque derivatives activity," Hoenig said in remarks before the Exchequer Club, a regular meeting of banking policy stakeholders.
"Such an outcome strikes me as a counterintuitive and jarring abandonment of postcrisis regulatory initiatives. For myself, as a U.S. regulator, I would be hard pressed to support proposals that weaken the leverage treatment of derivatives for U.S. banking organizations."
Hoenig has been a vocal advocate of a strong leverage ratio for years, helping to spearhead efforts by U.S. regulators to develop a tougher leverage ratio than in standards set by the international Basel Committee. Rather than assess capital strength on a risk-based basis like other ratios — which apply weights to assets based on their level of riskiness — the leverage ratio is a simpler and more rigorous standard that puts all assets in one risk bucket.
"U.S. bank capital regulation has a long tradition of using a leverage ratio, which goes a long way to explaining why large U.S. banks are generally stronger than large European banks," Hoenig said. "This relatively stronger capital position of the U.S. banking system is a competitive strength for us as a country, and for our banks."
But some industry groups say the leverage ratio has created a disincentive for derivatives trading to move toward central clearing. The negative effect on a bank's leverage ratio of including certain collateral posted in swaps deals goes against the purpose of margin requirements, they say.
"The leverage ratio is designed to require banks to hold capital against actual exposures to loss, yet the current construct fails to consider existing market regulations that mitigate such losses," the heads of financial industry trade groups and exchanges wrote in an August letter to the Financial Times responding to an earlier op-ed by Hoenig.
"Unlike making loans or taking deposits, guaranteeing client trades exposes the bank to losses only to the extent that the margin collected is insufficient to cover the clients' clearing obligations."
In a March speech, Timothy Massad, chairman of the Commodity Futures Trading Commission, said regulators were exploring ways to change how cleared derivatives are affected.
"While I appreciate the fact that the bank regulators want to have a leverage ratio that is not based on risk-weightings of assets, I am concerned that the rule as written could have a significant, negative effect on clearing, which is obviously a key policy goal of the Dodd-Frank Act," said Massad. "I have spoken with my fellow regulators on this issue and our staffs are talking to see if there is a way to address these concerns."
But Hoenig noted in his speech that margin instruments are not risk-free, and said the requirement for clearing swaps transaction is "a limited mandate."
"In the context of clearing, the clearing members typically are able, within certain parameters, to invest the cash initial margin. They assume risk, and they receive and earn income," he said. "If clearing member [futures commission merchants] wish to avoid balance sheet treatment for the collateral, contracts can be modified, in part by the FCM forgoing any right to investment income from the collateral. If the resulting contract ensures the FCM truly is acting merely as an agent, it need not record an asset. Some institutions have done this."