Eugene Grygo, Chief Content Editor, FTF News
Amid all the endless claptrap about interest rates, the Federal Reserve Board quietly this week proposed a rule that might help global markets sidestep widespread panic if a very large institution goes bankrupt and has lots of bilateral derivatives contracts on its books.
The proposed rule would delay the immediate cancellation of qualified financial contracts (QFC) in the case of bankruptcy for “U.S. global systemically important banking institutions (GSIBs) and the U.S. operations of foreign GSIBs” that are a party to a QFC.
The reason that this is important is that QFCs are the basis for derivative transactions, securities lending, and short-term funding arrangements such as the popular repurchase agreements.
“The proposal would apply to bilateral, uncleared QFCs,” according to the Fed. “Because GSIBs conduct a large volume of transactions through these contracts, the mass termination of QFCs may lead to the disorderly unwind of the GSIB, spark asset fire sales, and transmit financial risk across the U.S. financial system.”
The rule is an effort to bolster U.S. financial stability by “enhancing the resolvability of very large and complex financial firms,” which I think means making a bankruptcy of a big bank a little more orderly.
The proposed rule would have GSIBs and their foreign branches “amend contracts for common financial transactions to prevent the immediate cancellation of the contracts if the firm enters bankruptcy or a resolution process,” according to the Fed. “This change should reduce the risk of a run on the solvent subsidiaries of a failed GSIB caused by a large number of firms terminating their financial contracts at the same time.”
The proposal would also require GSIBs and their QFCs “restrict the ability of counterparties to terminate the contract,
Daniel K. Tarullo, Board of Governors, Federal Reserve System
liquidate collateral, or exercise other default rights based on the resolution of an affiliate of the GSIB,” Fed officials say. This restriction on default rights will allow the viable GSIB affiliates to meet their obligations and avoid being forced into a resolution “by the failure of another affiliate” that is deep trouble.
Fed officials say they are conforming to the restrictions on financial contracts under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act for the orderly resolution of financial firms. “By requiring GSIBs to make clear in their QFCs that the U.S. special resolution regimes apply, the proposal would help ensure that all QFC counterparties — domestic and foreign — would be treated in the same way in an orderly resolution,” the Fed says. “Under the proposal, GSIBs may also comply by using QFCs that are modified by the International Swaps and Derivatives Association (ISDA) 2015 Resolution Stay Protocol.”
ISDA members wrote the protocol in coordination with the Fed, the Federal Deposit Insurance Corp. (FDIC), the Office of the Comptroller of the Currency, and foreign regulators, say Fed officials.
The proposal complements previous moves by the Fed and the FDIC to “address the risk QFCs pose to financial stability through their review of the firms’ resolution plans,” says Daniel K. Tarullo, one of the seven members of the Board of Governors of the Federal Reserve System, in a prepared statement.
The proposal is currently being reviewed via commentary period that is open until August 5, 2016.
Given the insanity that followed the collapse of Lehman Brothers in 2008, which kicked off the Great Recession, I’m surprise this wasn’t sorted out earlier. However, it’s encouraging that it’s underway.
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