Playing “pretend” with credit risk

On Thursday last week, members of the US House of Representatives Michael G. Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA), and Bill Owens (D-NY) introduced a bill to add another dangerous loophole to the Dodd-Frank legislation’s capital and margin requirements on OTC derivative dealers.

It’s even more difficult than usual for those not on the inside to grasp what is going on here. The press release is all about motherhood and apple pie, and the bill itself is all about amending Section 4s(e) of the CEA as added by section 731 of the Dodd-Frank Act so that paragraphs (2)(A)(ii) and (2)(B)(ii) do not apply when, blah blah blah. The real substantive issue isn’t touched on explicitly in either source. But here’s the deal as far as I can tell.

The bill is an attempt to block swap margin and capital requirement rules proposed last April by a set of financial regulators.

This bill demands that financial regulators turn a blind eye to certain specific risks on a bank’s balance sheet. If the risk arises from the sale of a non-margined derivative to an end-user, the bank is supposed to pretend the risk doesn’t exist. The regulator cannot demand that the bank hold capital against that risk.

All derivatives sold by banks to end-users entail a certain amount of credit risk. Non-margined derivatives involve greater credit risk than a comparable margined derivative. Banks carefully assess the credit risk, charge the end-user for the credit risk, and manage the total credit risk on their balance sheet. For each end-user the bank maintains a credit file. Each sale is approved by the appropriate credit officer. And so on. The bank evaluates credit granted through the sale of derivatives just as it evaluates credit granted in various other forms—whether in the form of a loan or line of credit or any other structure.

Financial regulators need to examine the bank with the same gimlet eye the bank itself uses in evaluating the credit extended to its customers. Regulators should assess the bank’s overall credit portfolio, including the credit granted through the sale of derivatives to end-users. The regulator should recognize the differential credit risk arising through margined and non-margined derivatives.

This legislation seeks to tie the regulators’ hands. For credit risk accumulated through a variety of other loans, credit lines and similar products, the regulator is free to properly assess risk and demand the bank set aside an appropriate amount of capital. But credit risk associated with the sale of non-margined derivatives to end-users is to be privileged and exempt.

This isn’t wise legislation. Capital rules for banks need to be rational if taxpayers and the public interest is to be protected. A risk is a risk is a risk. If a derivative sold to an end-user without a margin creates a credit risk, we should want our financial regulators to call that spade a spade. When legislators start creating special categories of risks which regulators are directed to pretend don’t exist, it’s a recipe for yet another financial disaster.

We’ve seen this movie before. Back in the early 1980’s, when the savings and loan industry was in poor financial health, the government pursued a policy of regulatory forbearance which included pretending that certain savings and loan’s had more capital than they truly had. A variety of forms of fictitious capital were devised. But fictions are fictions, not capital, as taxpayers later learned.

Risks are risks, too. If this legislation passes and this loophole is created, we may have to learn this simple fact all over again.

One Trackback

  1. […] They hope to thereby lower the cost paid by end-users. We explained the problems with this bill in an earlier post. It is an ill informed attempt to preserve a back door subsidy. It risks leaving the financial […]

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