The US Chamber of Commerce is hosting a “fly-in” of corporate representatives tomorrow to lobby Congress and regulators on derivatives reform. They are advocating for a House bill (H.R. 1610) that would block financial regulators policing the risk on bank balance sheets.
The Chamber says it wants to allow end-users to buy swaps and other derivatives without posting margin.
But that’s not really what’s at issue. The Dodd-Frank Act already includes a specific exemption for end-users who are hedging their business operations.
What’s at issue is how much credit risk ends up on the balance sheet of banks. Banks are free to sell end-users non-margined swaps. But each non-margined swap the bank sells adds credit risk to the bank’s balance sheet. That credit risk adds up.
A prudently managed bank will have policies, procedures and controls to assess how much total risk it has in its portfolio of non-margined swaps. It will have to put aside capital in proportion to the risk.
Not all banks can claim to have an impeccable track record in managing the risks on their derivatives portfolios. As if 2008 wasn’t enough of a lesson, the recent $2.3 billion loss at UBS is another reminder. Apparently at UBS the cause was compliance failure. Systems cost banks money, and the incentives to dedicate resources to maintain controls at times vanish. Remember BP’s Horizon deepwater well? No difference, here.
Risk management is also quite challenging when banks and swap dealers offer counterparties tailor-made and complex derivatives contracts – the so called Level-3 assets, which may not trade and are priced based on an in-house model, precisely the swaps that are non-margined.
All this calls for banks to put aside more resources to manage risks and more capital. The problem is that both eat into banks’ return on equity.
In April, five regulators – the Federal Reserve Board, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Office of the Comptroller of the Currency – published a proposed rule detailing what would be required of the banks. Under the rule, banks are free to sell an end-user a non-margined swap. But banks must have appropriate policies in place to assess and manage the risk and must put aside capital to cover the risk.
H.R. 1610 is a directive to the financial regulators to turn a blind eye to the credit risk from non-margined swaps.
From exemption to exemption, from special case to exception, if we follow the Chamber down this path, we will find ourselves in another financial mess.