WASHINGTON — The Federal Reserve Board of Governors voted unanimously Friday to approve a final rule limiting the largest U.S. banks’ ability to enter into contracts with early termination clauses, a regulation intended to forestall a liquidity crunch if the bank is under stress.

Federal Reserve Gov. Jerome Powell, who chairs the board’s supervisory committee, said the rule, which covers certain uncleared swaps, repurchase agreements and securities lending contracts, would better ensure that a distressed firm could be resolved more easily.

“This final rule on QFCs that we are considering today is an important element of our strategy to make large banking firms more resolvable,” Powell said, referring to qualified financial contracts. “The final rule should help avoid the threat of a disorderly and mass unraveling of QFCs, as occurred in the case of Lehman Brothers, which intensified and prolonged the financial crisis.”

Fed Gov. Jay Powell
“The final rule should help avoid the threat of a disorderly and mass unraveling of QFCs, as occurred in the case of Lehman Brothers, which intensified and prolonged the financial crisis," said Fed Gov. Jerome Powell.

The final rule is close to a 2016 proposal that would bar global systemically important banks, or G-SIBs, from entering into certain qualified financial contracts that include early termination provisions earlier than 48 hours from notice of bankruptcy. The plan would effectively place a stay on counterparties' ability to call certain derivatives, repurchase agreements, reverse repurchase agreements and certain securities transactions in order to give regulators time to stabilize the failed bank without liquidity draining from the institution.

A memorandum accompanying the final rule said that the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency would be adopting "substantively identical final rules ... in the near future" that would apply to financial institutions under their purview.

The proposal sprang from a 2011 plan by the Financial Stability Board, an international standards-setting organization affiliated with the Group of 20 industrialized nations, that suggested that limiting early termination clauses would facilitate post-bankruptcy resolution and reduce contagion risk.

Many of the requirements in the rule simply codify changes that had already been happening in the derivatives market for some time — changes that were largely informed by regulators’ stated goal of restricting early termination rights as part of implementing Title II of the Dodd-Frank Act.

In 2014, 18 major global banks — including the eight U.S.-based G-SIBs — voluntarily agreed to stay early termination rights for the longer of one business day or 48 hours after bankruptcy as part of an international protocol brokered by the International Swaps and Derivatives Association. That master agreement, known as the ISDA protocol, was effectively retroactive, affecting nearly every applicable contract both going forward and already in place.

During the board meeting on Friday, Fed Chair Janet Yellen asked the Fed staff what effect the changes would have on the broader market for the contracts in question. Anna Harrington, senior supervisory financial analyst for the board, said the “overwhelming majority” of the contracts in question are executed by G-SIBs, so their adoption of the rules would likely emerge as a “best practice” across the market.

Fed Vice Chair Stanley Fischer, meanwhile, asked whether the contract provisions described in the rule might migrate to slightly smaller firms not designated as G-SIBs and therefore not subject to the rule. Sean Campbell, associate director of the program direction section of the Fed’s supervision and regulation office, said that if smaller non-G-SIB banks acquired a significant market share of the contracts described in the rule, they would likely increase their systemic risk enough to become G-SIBs in their own right.

“The extent to which banks engage in [over-the-counter] derivative activity is a factor that is considered in the determination of whether or not they are a G-SIB,” Campbell said. “So if you had someone who was on the bubble, and they tried to pick up a lot of activity … if they picked up enough of that activity, they would cross the line into G-SIB territory.”

The final rule makes some minor changes to the original plan.

For example, it narrows the spectrum of contracts covered by the rule to exclude those that do not have default rights.

The final rules also contemplates the applicability of any future universal protocol that would enact certain protections for buy-side participants, providing a “safe harbor” for adherents to a future protocol that includes such protections. The ISDA protocol, for example, could conceivably apply to QFCs between buy-side firms, which a Fed official is beyond the scope of the rule.

The final rule also introduces a staggered phase-in period for compliance based on the types of counterparties the GSIB has on the other end of its QFCs. Contracts between G-SIBs would be required to comply “on the first day of the calendar quarter immediately following one year from the effective date of the rule.” By contrast, contracts between G-SIBs and community banks would have two years to comply, and all other contracts would have an 18-month compliance deadline.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.