On the face of it, regulators and politicians worldwide are in complete agreement. Standardised over-the-counter derivatives should be cleared through central counterparties; higher capital requirements are necessary, as are strict liquidity standards; and no bank should ever be too big to fail. A variety of global bodies are pushing the requisite changes through, including the Group of 20 (G-20), the Financial Stability Board and the Basel Committee on Banking Supervision. In theory, then, what should emerge is a set of standards that everyone agrees with, implemented consistently in every jurisdiction.
That was never going to happen – national regulators have always been sensitive to the peculiarities of their own markets, and have looked to fine-tune global standards to suit their local banking systems. But what is now emerging from national supervisors goes well beyond that, to the extent the various regulations are actually inconsistent in certain areas, bankers claim. Some of the rules also appear to have an extraterritorial reach, which could mean global banks have to meet certain requirements that are at odds with their domestic rules.
The Volcker rule is a case in point, bankers say. Part of the Dodd-Frank Act, the rule is designed to prevent banks from engaging in proprietary trading, as well as owning, sponsoring or investing in hedge funds or private equity funds. Crucially, the rule applies to the non-US operations of US banks and to foreign banks that have a US branch, unless they can prove they meet certain exemption criteria.
“In an ideal world, we would have preferred to have seen more convergence and co-ordination on global regulations,” says Eraj Shirvani, co-head of global credit products at Credit Suisse, and a former chairman of the International Swaps and Derivatives Association. “The extraterritoriality of some US regulations and the many divergences on timetable and details show how, for example, there’s room for greater co-operation between different jurisdictions.”
The Volcker rule contains several exemptions to the prop trading ban, including trading in certain US government securities, underwriting, market-making and risk-mitigating hedging. According to a detailed rule published by four US regulators last year, certain foreign banking entities would also be exempt, so long as any prop trading activity takes place outside the country. However, the foreign bank must prove to US regulators that any banking entity that engages in prop trading is not organised under the laws of the US, no US residents are party to the transactions, none of the prop traders are located in the US, and the trades are executed wholly outside the US. Just proving they meet the exemption would require foreign banks to undergo a huge compliance process – a requirement essentially set by an overseas regulator (Risk November 2011, page 6).
In an ideal world, we would have preferred to have seen more convergence and co-ordination on global regulations
The exemption for US government securities has also prompted criticism, both from bankers and foreign regulators. Not only are US banks and their overseas operations important liquidity providers in foreign government bond markets, but foreign banking entities would need to meet the exemption criteria – meaning they couldn’t offload any proprietary government bond positions to US investors. The end-result will be reduced liquidity in non-US government bond markets, some claim.
Even some US regulators are nervous about these extraterritorial implications. “Major issues with the Volcker rule arise because one country is trying to do what it thinks is right for its market, but must then grapple with the international and extraterritorial features of the policy and try to reconcile that as best it can without actually converging with regulation in other countries,” says John Walsh, who was acting head of the Office of the Comptroller of the Currency (OCC) in Washington, DC until early April.
This isn’t the only example of extraterritoriality in Dodd-Frank. Section 716 – otherwise known as the swap push-out clause – also has some potentially troubling implications for foreign banks. This clause prohibits federal assistance to any swaps entity, including access to the Federal Reserve discount window and guarantees from the Federal Deposit Insurance Corporation (FDIC) – essentially forcing banks to shift their swaps businesses into separate entities in order to continue to access these facilities.
Again, there are some exemptions – insured depository institutions are allowed to use derivatives to hedge and can also conduct traditional banking activities, as described in US federal law. This has been interpreted to mean banks can act as market-makers on interest rate and foreign exchange derivatives, gold and silver swaps, and cleared credit default swaps (CDSs). Other businesses – equity derivatives, commodity derivatives and non-cleared CDSs, for instance – would have to be moved into separate affiliates.
This could pose significant problems for foreign banks, however. Most US branches of foreign banks do not take deposits and are not covered by FDIC insurance, but do access the Fed discount window. This means none of the exemptions would apply to foreign banks as the legislation currently stands, requiring them to carve out their entire US derivatives businesses into separate entities if they want to continue to access the discount window.
Even worse, because the US branch is part of the same legal entity as the parent bank overseas, it is possible the rules could end up applying to the entire group. Many lawyers doubt US regulators will go as far as to expect foreign banks to carve out their global swaps operations, but they warn the legislation as it stands could be interpreted so that it applies to the foreign branches of US banks, giving it a strong extraterritorial application. This ties in with another area of uncertainty – the swap dealer registration rules.
Most foreign banks tend to solicit derivatives business with US clients through their US branches, but book the trades through an overseas banking entity. This could mean these foreign banks have to register as swap dealers, requiring them to meet US regulatory disclosure rules and be subject to oversight by the Commodity Futures Trading Commission (CFTC) – potentially creating friction with home regulations.
The legislation could also apply to the non-US operations of US banks, even when conducting business with non-US entities. In other words, a client in Hong Kong, for example, might have an incentive not to trade with a Hong Kong branch of a US bank, as it may be subject to Dodd-Frank rules – a standardised derivatives trade would then need to be cleared through a CFTC-registered derivatives clearing organisation, and an uncleared trade would be subject to stringent margin requirements proposed by US prudential regulators in April 2011 (Risk June 2011, pages 24–27).
These kinds of implications – particularly those that would put US banks at a competitive disadvantage – have started to garner the attention of US politicians, and several bills are working their way through Congress that would water down certain aspects of the rules. For instance, HR 1838 would modify the swap push-out clause, ensuring both foreign and domestic banks are treated equally, and narrowing the scope so only swaps referenced to asset-backed securities need to be transferred to separate entities. It also clarifies that the rule would not apply to swaps activity conducted outside the US by a non-US swaps entity with a non-US counterparty. In other words, a foreign branch of a US bank trading with a non-US firm would not be subject to section 716 if the bill is passed.
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