Tags: bank | fed | counterparty

Banks Fight Fed's Push to Make Them Less Entwined

Monday, 25 Jun 2012 03:12 PM

Wall Street is ramping up a campaign against rules that are designed to prevent financial firms from being too interconnected, arguing that the regulations could backfire and hurt markets.

The rules, which limit financial institutions from having too much exposure to any one party, have not grabbed nearly as much attention as the Volcker rule. But Wall Street banks fear they could hurt their profits as much - if not more.

The Federal Reserve proposed the "counterparty exposure" rules late last year, as required by the 2010 Dodd-Frank financial oversight law. If banks have too many links to one another, the demise of any one financial company can set off a domino effect and imperil the system.

The rules apply to multiple businesses, but many financial institutions worry the biggest impact could be on their derivatives businesses, which banks could be forced to trim.

So far, dealers have responded directly to the Fed with comment letters. Some executives are also griping about the rules behind closed doors.

The Fed has received 97 comment letters on the topic from major Wall Street firms and others, according to its website. In comparison, the Fed drew only 12 comment letters about the Volcker rule.

Several big-bank chief executives, including JPMorgan Chase & Co's Jamie Dimon and Goldman Sachs Group Inc's Lloyd Blankfein, also personally voiced concerns to Federal Reserve Governor Daniel Tarullo about the rule at a meeting in May.

A Wall Street trade group called The Clearing House is expected to issue a report this month with the industry's full assessment of the rules' impact on markets and the U.S. economy.

Regulators and risk-management experts argue that Wall Street firms are just looking to protect their profits in lucrative derivatives markets, which in the United States are largely controlled by a handful of banks.

JPMorgan, Citigroup Inc, Bank of America Corp and Goldman have roughly 93 percent of the U.S. derivatives market among companies that trade mainly out of their regulated banking subsidiaries, according to data from the Office of the Comptroller of the Currency.

"They're fighting this for the same reason Standard Oil didn't want to be broken up at the turn of the century," said John Parsons, a senior lecturer at MIT Sloan School of Management, who specializes in derivatives and is a supporter of the Fed's proposal.

But financial firms and experts who work with them say the rules, as proposed, could have dangerous consequences because th ey overstate how connected banks are.

The rules "could raise the cost of capital, hurt liquidity and force institutions to take different risk-management approaches that may not be as effective," said Joel Telpner, a partner at the law firm Jones Day, who works with large financial institutions on derivatives matters.

"I just think there are a whole bunch of unintended consequences that haven't been completely thought through," Telpner said.

Derivatives are big business for dealers. U.S. bank holding companies received $52.78 billion of revenue from trading in 2011 - much of that from derivatives, according to the Office of the Comptroller of the Currency.

The Fed can still alter the proposed rules, which are set to go into effect in October 2013, and could a ffect businesses ranging from corporate lending to sovereign bond trading. But regulatory lawyers and analysts say there is no indication that Fed officials are poised to rewrite the entire thing.

 

EIGHTEEN TIMES MORE EXPOSED

The rules, known as the single-counterparty credit limit proposal, would force financial institutions with at least $500 billion of assets to limit exposure to one another to just 10 percent of capital.

Banks can have more exposure to smaller companies - the limit there is 25 percent of capital - on the theory that the demise of these companies would put less pressure on the financial system.

The industry is spooked by these rules in part because banks have so much exposure to one another and to clients under the Fed's proposed methodology for tracking trading connections.

U.S. banking titans are up to 18 times more exposed to one another under the proposed rule's methodology than banks consider themselves to be now, according to Goldman Sachs' comment letter to the Fed.

"Based on conversations I've had with clients, I don't think those numbers are unreasonable," said Sabeth Siddique, a director at Deloitte & Touche and a former head of credit risk at the Federal Reserve Bank of New York. "The market is consistently saying exposures to other counterparties are materially higher than 10 percent."

When an investor buys a stock or a bond, the transaction is complete in seconds.

With an over-the-counter derivatives trade, parties may agree to a contract quickly, but the cash flows can take years to exchange, leaving the two parties connected to one another for some time.

These connections mean that the financial system is only as strong as its weakest link.

During the financial crisis in 2008, regulators were reluctant to let Bear Stearns or American International Group Inc fail, for fear that their connections to other financial companies could topple banks, or at least panic the market and erode faith in the financial system. Taxpayers ended up taking enormous risk in helping to fund JPMorgan's rescue of Bear Stearns and the government's bailout of AIG.

Senior executives at Wall Street banks acknowledge that counterparty exposure is still a huge issue. Shares of companies like Goldman Sachs and Morgan Stanley have been pressured for the better part of a year over concerns about exposure to European counterparties.

 

GROSS VS NET FIGURES

Banks, in their comment letters, objected to the methodology that the Fed uses to determine banks' exposure to trading counterparties.

Calculations under the proposed rule use gross figures, rather than net figures, to determine exposure. So a bank that used derivatives to buy exposure to $1 million of IBM Corp shares in one trade and sell exposure to $1 million of IBM shares in another trade with the same party could have $2 million of exposure, minus collateral and other items, in the Fed's estimation. Banks believe that because the two trades are essentially opposites, they should net out to zero.

"Banks are not opposed to the rule. They are just opposed to this model because they think it overstates the risk," said Carter McDowell, associate general counsel of the Securities Industry and Financial Markets Association, a trade group representing capital markets participants.

 

CLEARINGHOUSE MANDATE

Banks also argue that the proposed rule overlooks important issues related to other regulatory reform proposals - particularly banks' exposure to clearinghouses. New rules will require banks to trade directly with a clearinghouse rather than their customer or another bank.

Clearinghouses make the financial system safer by ensuring that parties are posting enough collateral, and that positions can be easily reassigned if a player fails. But they also result in banks having outsized exposure to one entity, namely the clearinghouse.

The treatment of joint ventures may also be an issue.

Morgan Stanley, for instance, has two trading joint ventures with Mitsubishi UFJ Financial Group Inc in Japan. Under the Fed's proposal, Morgan Stanley and Mitsubishi would both have to consolidate all of the trading operations' credit exposure into their own, effectively double-counting it.

Morgan Stanley is also a top derivatives dealer in the United States, but has historically done most of its trading outside of its regulated bank subsidiary.

The rule might also require Morgan Stanley to reduce overexposure to certain counterparties in Japan, ranging from Mitsubishi - which has a major investment in Morgan Stanley stemming from a capital injection during the 2008 fi nancial crisis - to the Japanese government. Both the Bank of Japan and Banco de Mexico submitted letters to the Federal Reserve expressing concerns that the proposal would hurt their ability to issue sovereign debt.

Still to some risk management experts, the rules will only help the market.

"It's better for the economy to have a competitive derivatives market than one that's controlled by a monopoly," said Donald van Deventer, head of the risk-management firm Kamakura Corp. "What the banks are saying is purely self-interested."

© 2017 Thomson/Reuters. All rights reserved.

 
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2012-12-25
Monday, 25 Jun 2012 03:12 PM
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