The largest U.S. banks can remain entangled with each other now that global regulators have loosened proposed limits on the financial web that led to investor panic in 2008 and prompted bailouts.
The Basel Committee on Banking Supervision, which set out a year ago to block banks from relying too heavily on each other, changed course last week, opting to let firms preserve most derivatives and repurchase agreements among themselves. The panel revised formulas for evaluating exposure and used a broader definition of capital. Those tweaks spare about $1 trillion in deals at seven of the biggest U.S. banks that would have exceeded proposed limits, according to a November study by the Clearing House, an industry group.
The Basel panel of regulators from 27 countries has bowed to industry pressure before to weaken new rules. Liquidity standards and leverage ratios also were altered so the largest firms came much closer to being in compliance.
“That seems to be the name of the game, fighting every rule to the ground,” said Anat Admati, a Stanford University finance professor. “The fact that the banks were so concerned with counterparty limits and fought them so hard shows how interconnected they are. That makes them too big to fail.”
The exposure rule, set to take effect in 2019, seeks to ensure that lending and trading by banks are so diversified that the failure of a single customer or counterparty won’t bring them down. That threat was a theme of the credit crisis, when Lehman Brothers Holdings Inc.’s collapse led investors to pull money from other financial firms on concern that losses would spread. The Federal Reserve and the U.S. Treasury Department’s bailout of New York-based American International Group Inc. helped save banks whose mortgage bonds the company had insured.
Ninety-five percent of derivatives contracts in the U.S. banking system were concentrated at JPMorgan Chase & Co. (JPM:US), Citigroup Inc., Bank of America Corp. (BAC:US), Goldman Sachs Group Inc. and Morgan Stanley (MS:US) at the end of last year, according to the Office of the Comptroller of the Currency. The data don’t show to what degree they are counterparties to each other.
The Too-Big-to-Fail Guarantee
Bankers themselves have acknowledged there are high levels of interconnectedness.
“The reality on the international level shows that the really central topic is not ‘too big to fail,’ but rather ‘too interconnected to fail,’” said Urs Rohner in 2009 when he was vice chairman of Zurich-based Credit Suisse Group AG, Switzerland’s second-largest bank.
In March 2013, the Basel committee proposed a new way of calculating how much money banks stood to lose on their derivatives deals. While the panel set a ceiling for total exposure to any one party, including nonfinancial firms, at 25 percent of a bank’s capital, 29 institutions deemed systemically important faced a tighter threshold of 10 percent to 15 percent for dealings with each other.
The Clearing House, representing 21 of the largest commercial banks in North America and Europe, released estimates after Basel’s proposal, showing how much seven of the largest banks would collectively exceed exposure limits. The study included scenarios showing the rule’s impact if changes were made to satisfy different objections.
The organization hasn’t updated the study since the rule was revised, and the New York-based group’s director of research, Sridhar Iyer, wouldn’t give an exact figure for the reduced impact.
“These changes are reflective of certain critical industry concerns and will better allow the industry to continue to play its traditional role in the derivatives market,” Iyer said.
In comment letters to the Basel committee and other regulators, the Clearing House, the Institute of International Finance and other industry groups argued that regulators were overestimating the true exposure of banks as a result of derivatives trades and repo lending. Bank groups predicted that restrictions on such transactions would hurt the $693 trillion derivatives market, where companies hedge price risks, and the repo market, which helps governments sell debt.
The Basel committee’s most significant changes to the proposed methodology last week affected how derivatives and repo exposures are calculated. It picked 15 percent as the limit for systemic banks instead of 10 percent. The panel also chose Tier 1 capital, which includes preferred securities, instead of only common equity as the base for calculating the exposure ratio.
On the derivatives side, the proposed methodology would have forced banks to report a sixfold increase in the risks they calculate under their internal models, the Clearing House estimated. The final rule only doubles those figures.
The committee also modified a proposal that would have forced banks to add in their exposure to the issuer of a bond used as collateral in a derivatives trade. If a bank buys a credit-default swap from a hedge fund that posts Italian sovereign bonds as collateral, the bank would be exposed both to the Italian government and the fund. That requirement was eliminated in the final rule unless the collateral is issued by another bank or financial institution.
On repos, a form of short-term lending secured mostly by bonds, the committee abandoned its proposal and said it would come up with one closer to how banks determine the risk from derivatives deals. If a new measure isn’t written before the rule goes into effect, banks can continue using their own math.
The Clearing House estimated that harsher treatment of derivatives and repos, along with other proposed rules, would leave the seven U.S. banks with $860 billion in trades exceeding limits. That figure, which assumed Basel would ease its stance on derivatives somewhat, would have been higher with the sixfold increase in the original methodology. The group’s report didn’t include an estimate for the toughest measure because the seven banks, which weren’t identified, didn’t provide enough data.
The weakening in the final rule will wipe out almost all of that overage, according to the organization’s estimates. The Clearing House didn’t include any of the other 22 systemically important global banks in its study.
Ruth Porat, chief financial officer of New York-based Morgan Stanley, hailed the change in the derivatives formula.
“We think that’s a better measure of exposure, so that’s probably the most important” change in the regulation, she said in a phone interview last week.
Spokesmen for New York-based JPMorgan, Goldman Sachs, Citigroup and Charlotte, North Carolina-based Bank of America declined to comment.
While the new proposal is stricter than limits that have been in place for more than two decades, the revisions mean banks are significantly closer to compliance than they would have been under last year’s draft.
Banks had similar successes with a liquidity standard requiring lenders to have enough easy-to-sell assets to meet a sudden withdrawal of funding. Under a 2010 proposal, banks would have had a shortage of $2.3 trillion of long-term funding to comply with the rule. Revisions completed in January 2013 reduced that to $750 billion.
The leverage ratio, which sets a minimum capital buffer based on total assets regardless of how risky they are, also was softened in January this year, blunting its impact on the largest firms.
The world’s biggest banks typically disclose little or nothing about how heavily they rely on peers as counterparties. Citigroup offered a peek in its annual filing in March. The New York-based lender said more than 80 percent of its credit-derivatives exposure was to other banks or broker-dealers, without breaking it down by firm. That amounted to about $34 billion at fair value and almost $1 trillion of notional value, which is the raw figure before netting for collateral and other risk-reduction measures. The bank didn’t provide an industry breakdown for other derivatives.
The focus now shifts to the Federal Reserve, which needs to complete an exposure rule initially proposed in December 2011, said Gregory Lyons, a partner at law firm Debevoise & Plimpton LLP in New York.
The Fed’s proposal faced criticism from the industry when introduced. Its method for calculating derivatives was the same as Basel’s earlier proposal, and the Fed looked to set a 10 percent limit on exposures between the largest lenders. The central bank, a Basel member, has said it will wait for the international standard before completing its own.
“Basel softening some of these elements at least raises the possibility that the Fed might as well,” said Lyons, co-chairman of the firm’s financial institutions group. “Sometimes the Fed doesn’t mind going beyond the global standard, but will they be tougher than Basel on the exposure rule?”
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