Banks Back Swap Contracts That Could Help Unwind Too-Big-to-Fail

By Gregory Mott

Photographer: John Zich/Bloomberg

International Swaps and Derivatives Association’s chief executive officer Scott O'Malia.

Eighteen global banks have agreed to swaps contract changes designed to work with government rules for unwinding failed firms, a step that may help end the view that some financial companies are “too big to fail.”
Counterparties of banks involved in resolution proceedings will delay contract termination rights and collateral demands under the plan announced by the International Swaps and Derivatives Association. The change is intended to give regulators more time to arrange orderly resolutions, ISDA said in a statement released in Washington on Saturday.
“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk,” Scott O’Malia, ISDA’s chief executive officer, said in the statement. The agreement will “facilitate cross-border resolution efforts and reduce the
risk of a disorderly wind-down,” he said.
ISDA, the main industry group for the $700 trillion global swaps market, changed the language in a new standard contract under pressure from U.S. regulators, according to three people with knowledge of the talks. The regulators had expressed concern that close-outs of derivatives transactions could hinder resolution efforts and roil markets, ISDA said.
The new protocol, which lets banks opt into overseas resolution regimes that might otherwise apply only to domestic trades, initially will cover 18 major banks including JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS), HSBC Holdings Plc (HSBA) and Credit Suisse Group AG. (CSGN) The agreement, set to take effect Jan. 1, extends coverage of the delays, or stays, to 90 percent of the outstanding notional value of derivatives, ISDA said.

Bankruptcy Law

Under U.S. bankruptcy law, derivatives including swaps are exempt from the stay that keeps creditors of a failed firm from immediately collecting what they’re owed. That means banks’ swap counterparties could move quickly to seize collateral.
Such a rush would make an orderly bankruptcy impossible, according to the Federal Reserve and Federal Deposit Insurance Corp., the agencies supervising the living-will plans banks must develop under the 2010 Dodd-Frank Act. In August, the regulators rejected plans from 11 of the largest U.S. and foreign banks, telling them to simplify their legal structures and address the bankruptcy exemption for swaps.
The Fed and FDIC released a statement welcoming the ISDA initiative as important step in reducing financial stability risks that would result from the the failure of a global bank “with significant cross-border derivatives activities.”

Credible Plans

Regulators have said a pause in the collection of swaps collateral could give a bank enough time to re-capitalize and avoid the kind of panic that followed the 2008 failure of Lehman Brothers Holdings Inc. They theorize that having a credible plan for unwinding failed banks would help end the perception by some market participants that governments will bail out firms that are too big to fail.
“This is a huge step forward,” Clearing House Association President Paul Saltzman said in a statement. “Voluntary adoption of the ISDA protocol further demonstrates the industry’s commitment to ensuring that even the largest global banks can be resolved in an orderly way without cost to taxpayers.”
ISDA, backed by swaps dealers such as Goldman Sachs and JPMorgan, sets worldwide standards for derivatives -- complex financial instruments whose value is tied to another asset, such as loans or stocks.
Other banks covered by the agreement are Bank of America Corp., Bank of Tokyo-Mitsubishi UFJ, Barclays Plc (BARC), BNP Paribas SA (BNP), Citigroup Inc. (C), Credit Agricole SA (ACA), Deutsche Bank AG (DBK), Mizuho Financial Group Inc. (8411), Morgan Stanley (MS), Nomura Holdings Inc. (8604), Royal Bank of Scotland Group Plc, Societe Generale SA (GLE), Sumitomo Mitsui Financial Group Inc. (8316) and UBS AG. (UBSN)

FSB Statement

The Financial Stability Board called on all systemically important banks and other companies with significant exposure to derivatives to adopt the protocol by the end of 2015 and urged them to ensure new contracts allow cross-border stays.
“This is a major achievement, by the industry,” Bank of England Governor Mark Carney said in the FSB statement. “We now need to extend this process to other financial market participants, and to other financial contracts that pose cross-border close-out risk in resolution.”
Carney is acting as chairman of the FSB, which coordinates at the international level the work of national financial authorities and international standard setters.