All Announced on One Day: Five Banks Fined for FX, One for Precious Metals and BOE Chief FX Dealer Fired

As had been rumored for a few weeks, FX settlements between multiple regulators and several FX banks were announced on the same day, today. The banks prefer not to be singled out for misconduct but just to be one of many, so that this is viewed as more of a market problem. The banks were not found to have attempted to manipulate FX rates but instead found to have had ineffective controls allowing traders to engage in manipulative behavior. However, the DOJ is still looking into criminal charges, the New York regulator would not sign on to this agreement as it was felt to be too weak and penalties against many other banks by these same and other regulators will be forthcoming.

The Swiss regulator FINMA also fined UBS for precious metals misconduct, finding "clear attempt to manipulate precious metals benchmarks", particularly in the silver market. As FINMA also fined UBS for FX market violations, UBS would certainly have wanted both announcements at once.

Then the Bank of England hopped onto the bad news train today as well. They have been quiet for several months after announcing that an unnamed employee had been suspended for misconduct regarding FX. Today they announced that the chief FX dealer had been fired yesterday, but still provided little information, other than misconduct was discovered as part of the FX manipulation probe but the behavior itself was not related to the probe.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)