On May 3, 2016 the Federal Reserve Board (FRB) proposed a rule that aims to strengthen and provide stability to the financial markets.1 The proposed rule would require US global systemically important banking institutions (GSIBs) and the US operations of foreign GSIBs to amend contracts for common financial transactions to prevent the immediate cancellation of the contracts, if the firm enters bankruptcy or a resolution process. As a result, firms would need to wait at least 48 hours before taking actions on the contracts.2 The rule stems from the widespread sale of assets that rippled through the banking system in 2008 as Lehman Brothers declared bankruptcy, precipitated by counterparties exercising their rights to default on contracts and sell related collaterals. The proposal would mitigate marketplace contagion and destabilization, and work conjointly with the resolution plan.3
The FRB has opened the commentary period on all aspects of this proposed rule until August 5, 2016. The rule intends to increase GSIB resolvability by way of:
- Requiring GSIBs’ qualified financial contracts (QFCs) to contain contractual provisions that recognize the automatic stay of termination provisions and transfer provisions applied in resolutions under the Dodd-Frank Act and the Federal Deposit Insurance Act.
- Prohibiting a counterparty to the QFC to exercise default rights based on the entry into resolution of an affiliate of the GSIB.
- Requiring banks to conform QFCs from before the compliance date—the first day of the first quarter at least one year after the final rule takes effect—to the rule’s requirements if the bank or an affiliate enters into a new QFC with the same counterparty or an affiliate of the counterparty after the rule goes into effect.
- Extending the International Swaps and Derivatives Association (ISDA) stay protocol requirements beyond its current application to apply to QFCs of GSIBs with all counterparties.
The Office of the Comptroller of the Currency (OCC) is expected to issue a proposed rule that would subject national banks and federal savings associations that are GSIB subsidiaries to requirements substantively identical to those proposed here.
Qualified Financial Contracts5
Qualified Financial Contracts (QFC) are important classes of financial transactions, which play a valuable economic role in financial intermediation. QFC’s are defined to have the same meaning as in section 210(c)(8)(D) of the Dodd-Frank Act and would include, among other things:
- Asset classes including derivatives, repurchase agreements (also known as “repos”) and reverse repos, and securities lending and borrowing agreements.
- Being used primarily to borrow money to finance their investments, to lend money, to manage risk, and to enable their clients and counterparties to hedge risks, make markets in securities and derivatives, and take positions in financial investments.
- Being applied to bilateral and uncleared QFCs
Affected Financial Organizations6
The following types of financial organizations (“covered entities”) would be subjected to restrictions regarding the terms of their non-cleared qualified financial contracts (QFCs):
- US top-tier bank holding company identified by the FRB as a GSIB.
- Subsidiaries of US GSIB (other than federal savings associations and national banks).
- US operations of any foreign GSIB (other than federal savings associations and national banks).
This proposal focuses on two distinct scenarios in which a non-defaulting party to a QFC is able to exercise the rights described above.
- Direct Default – GSIB entity that is a direct party to the QFC enters a resolution proceeding
- Cross-Default – An affiliate of the GSIB entity that is a direct party to the QFC (such as the direct party’s parent holding company) enters a resolution proceeding
Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act8
According to the regulator, the proposal also helps maintain consistency with restrictions on financial contracts under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act that support the orderly resolution of financial firms. Title II of the Dodd-Frank Act imposes broader stay requirements on QFCs that enter resolution under that Title.9
- It establishes Orderly Liquidation Authority (OLA), an optional resolution framework to be used in rare occasions to help manage a firm’s failure (that poses significant risk to the financial stability) in a fashion that mitigates such risk and reduces moral hazard.
- It authorizes the Secretary of the Treasury to place a financial company into receivership (conducted by the FDIC as an alternative to bankruptcy) upon the recommendation of other government agencies and if several preconditions are met.
- It allows the FDIC to transfer the QFCs to a bridge financial institution or other financial firm that is not in a resolution proceeding and should therefore be able to perform under the QFCs.
The adoption of the rule builds on Dodd-Frank 165 and the US Bankruptcy Code regulations, requiring systemically important banks to amend QFCs, concurrently with the resolution plan process.
- The eight US firms the FRB had identified as being global systemically important have already adhered to this protocol as part of their resolution planning process.
- The proposal could impose costs on covered entities to the extent that they may need to provide their QFC counterparties with better contractual terms in order to compensate those parties for the loss of their ability to exercise default rights that would be restricted by the proposal.
- The proposal’s requirements would not apply to certain entities that are supervised by the OCC. The OCC is expected to issue a proposed rule that would be substantively identical to the above proposed requirements.
- Board of Governors of the Federal Reserve System, Press release, May 3, 2016. Access at: http://www.federalreserve.gov/newsevents/press/bcreg/20160503b.htm
- “Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions,” Board of Governors of the Federal Reserve System, 12 CFR Parts 217, 249, and 252. Access at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160503b1.pdf
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