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.)
