 "Fed Reserve proposes new rule capping business between banks")
One of the problems with big Wall Street banks in 2008 was that they had too many of their financial eggs in one basket.
When Lehman Brothers and the American International Group started to collapse, the banks that did huge amounts of business with those two firms faced the prospect of crippling losses. Speculation raged about how big those losses might be and how widely they might spread, stoking a panic that froze the global financial system.
Read more from our special coverage on "FEDERAL RESERVE"
The Federal Reserve on Friday proposed a rule that, in a relatively simple manner, sets out to lessen the chance of such contagion happening again. The rule effectively places a cap on how much business banks can do with another bank or company. The hope is that if a failing bank were unable to make payments on trades or loans, the losses at other banks would be limited. "In the financial crisis, we learned that the largest and most complex banks and financial institutions lent or promised to pay large amounts to other institutions that were also very large and complex," Janet L Yellen, chairwoman of the Fed, said in a statement. "These credit extensions and promises did not eliminate risk, and in many cases they magnified it."
The Dodd-Frank financial overhaul required the Fed to write the proposed rule on the cap, known as the single counterparty credit limit.
In 2011, when the Fed proposed a rule, the financial industry said it was too burdensome. The rule proposed anew on Friday appears to be less strict. The banks may welcome the latest version of the cap, especially because it will be less onerous on their operations that trade derivatives, the financial contracts that allow investors to make wagers on, say, interest rates and stock prices.
"This is a good day for banks with large derivatives exposures - they are no longer being punished for this business activity," Adam Gilbert, a partner at PwC, said in an email. "US regulators chose to soften their approach, to largely align with international standards, addressing concerns over international competitiveness."
Banking specialists who favour more stringent Wall Street rules expressed some concerns. In its revised rule, the Fed changed how it would measure the amount of derivatives trades. It appears to be using a method that diminishes the exposure to derivatives. "A derivatives exposure that looks small in normal times can become enormous in times of financial stress," said Marcus Stanley, policy director at Americans for Financial Reform. "This rule may not contain adequate protections against that kind of risk."
Fed officials, for their part, said that the changes in the newest version made the rule more sensitive to risks within the banks. And the Fed may yet decide to use the credit risk cap to press banks to hold more capital.
The Fed estimated that US banks had "less than $100 billion" of business that exceeds the caps. The central bank said the "firms could largely eliminate this excess exposure amount without materially disrupting their activities." Specifically, the proposed rule says that eight "systemically important" US banks cannot have loans or trades or other types of business with another large bank that exceed 15 per cent of their capital, the financial cornerstone of a bank. The cap in the first proposal was set at 10 per cent of capital. But the latest rule is stricter in one way: It uses a smaller measure of capital.
Under the first proposed rule, if a large bank had $9 of trades with another large bank, and $100 for capital, it would not have exceeded the 10 per cent threshold. But under the latest proposed rule, the measure of capital may be a lower $60 because it excludes types of capital that regulators and investors consider less solid. In that case, the $9 of trades would be 15 per cent of capital, putting the bank right on the threshold.
Smaller banks have more leeway under the proposed rule. The credit risk cap may be as high as 25 per cent, and the measure of capital may be more generous.
The Fed also allowed banks to exclude certain types of business from the tally of credit risk. They do not, for example, have to count bonds issued by the United States government.
Crucially, they also do not have to include business with certain so-called central clearinghouses. These are hubs that spread the risks of derivatives trades and have rules that are meant to prevent the build-up of hidden risks. If the Fed had not exempted certain clearinghouses, it might have reduced the incentive for the banks to direct trades through the clearinghouses.
After the Fed issues a final rule, United States banks will have one year to comply with it.
@2016 The New York Times News Service
