WASHINGTON - Federal regulators issued a rule Tuesday to bring U.S. capital and liquidity rules in line with a policy taking effect as early as Jan. 1 on international resolution procedures.
The regulation will ensure large U.S. banks with overseas operations are not penalized as a result of delaying termination rights in a derivatives deal. Termination delays - or "stays" - are seen as aiding regulators' ability to unwind failed firms. The U.S. rule, which goes into effect Jan. 1 and was issued by the Federal Reserve Board and Office of the Comptroller of the Currency, will also align the agencies' policy on lending limits with the steps taken abroad.
"The interim final rule is necessary to maintain the existing treatment for [derivatives] contracts for purposes of the regulatory capital, liquidity, and lending limits rules," the regulators said.
Early termination rights mitigate the risk of a party in a derivatives deal if another party defaults. Institutions in a derivatives transaction can include such rights in what are known as "netting agreements," which have a positive effect on a bank's capital position.
But Lehman Brothers' collapse showed that exercising those rights can disrupt the orderly wind-down of the failing firm and pose systemic threats. U.S. laws, including the Dodd-Frank Act, now impose a limited stay on termination rights for U.S. banks to assist the Federal Deposit Insurance Corp.'s authority to seize and unwind a failed behemoth.
Now foreign regimes are following suit. In October, the International Swaps and Derivatives Association announced agreement from 18 large banks on a new protocol for allowing such stays. The protocol is set to take effect Jan. 1. Meanwhile, the European Union's recent Bank Recovery and Resolution Directive signaled that E.U. countries may also impose termination stays.
While U.S. regulation already allowed banks to retain the favorable capital treatment for the purposes of the FDIC's resolution regime, the interim rule released Tuesday is aimed at allowing the same treatment in cases where an international jurisdiction imposes a stay. (The public has until March 3 to comment on the rule.)
"Without the interim final rule, several banking organizations would no longer be permitted to recognize financial contracts as subject to a qualifying master netting agreement or satisfying the criteria necessary for the current regulatory capital, liquidity, and lending limits treatment, and would be required to measure exposure from these contracts on a gross, rather than net, basis," the Fed and OCC's rule said. "This result would undermine the salutary effects of the BRRD and similar resolution regimes and the ISDA Protocol on financial stability."
In addition to avoiding a negative effect on capital requirements from the overseas policies, the rule issued Tuesday will also seek to retain favorable treatment from netting deals under the "Liquidity Coverage Ratio." The ratio - or LCR - classifies the types of assets banks must hold onto that can be sold in a liquidity crunch.
In addition to the Fed and OCC, the FDIC had been scheduled to consider a proposal as well dealing with the effects of the ISDA change. However, the agency delayed action on the proposal, taking it off the agenda for Tuesday's meeting of the FDIC's board of directors. The FDIC is expected to revisit the issue in January.