Proposed Swap Rule Could Hurt Banks

An accounting rule now in draft from could hurt banks active in the $3 trillion swap market.

The proposed amendment to Financial Accounting Standard 105 calls on companies to report their gross exposure on swap and foreign exchange contracts, a change from existing procedure that only requires banks to report net exposure.

The difference would be significant enough to boost banks' reported assets, cutting into their equity-to-assets ratio.

|A Major Impact'

"It would have a major impact on U.S. banks' balance sheets," said a money-center banker.

The new standard could have the greatest impact on big banking companies such as the New York money-centers. With their sophisticated trading operations, these companies are major players in the markets for interest rate and currency swaps.

By one estimate, money-center banks would have to add $13 billion apiece, on average, to their balance sheets, and several large regionals would have to add about $10 billion apiece.

Net Exposures Reported

Banks now report their net exposures on swap and foreign exchange contracts - their gains at current market values, less losses - on their balance sheets. Their gross credit exposure - what it would cost them to replace the contracts on which they have unrealized gains - is disclosed in footnotes to their financial statements.

The new rule would require banks to show the gross credit exposure on their balance sheets, except in cases where they have swap and foreign exchange contracts that explicitly allow for the use of net exposure.

Changing the rules would enhance disclosure of banks' financial condition, according to John Lawton, a practice fellow at the Financial Accounting Standards Board. "Everybody doesn't always read the footnotes," he said. "To the extent you can get information on the balance sheet, that's better."

Boosting Reported Assets

But it would also boost banks' reported assets.

Analysts and investors calculating banks' capital adequacy based on their consolidated financial statements would find smaller equity-to-assets ratios - a key measure of capital strength.

"It would add to nominal assets, if banks are netting things today they'd no longer be able to net," said Robert Storch, chief of the accounting section in the division of supervision at the Federal Deposit Insurance Corp.

Big Banks' Exposures

Bankers Trust New York Corp., for example, had gross credit risk exposure on swaps of $22.1 billion at yearend, and at least part of that would have to be added to its $64 billion balance sheet if the new rule had been in effect. Citicorp reported credit exposure on swaps and foreign exchange contracts of $24.5 billion. Chemical Banking Corp. had gross credit exposure on such contracts of $10.1 billion. And J.P. Morgan & Co. reported $9.3 billion in credit exposure not already included in a short-term asset account.

Banks could mitigate the effect of the rule change by stepping up their use of so-called master swap agreements when they enter into new contracts, and most already use such agreements on occasion. Master swap agreements explicitly allow two counterparties to net their credit exposure to each other when they have more than one contract outstanding between them, reducing the amount to be added to a bank's assets.

"This will stimulate the documentation of off-balance-sheet transactions under master swap agreements. That's good credit practice," said Mark Brickell, chairman of the International Swap Dealers Association.

Banks and industry groups have until mid-September to comment on the draft rule, and sources said the swap dealers group and bankers from the large New York banks are already preparing statements.

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