BoE warns banks on derivatives booking practices

Dealers must simplify if there is "no coherent rationale" to structures

The Bank of England: booking structures 'have grown barnacles'

The Bank of England (BoE) has warned banks to book trades to their various legal entities in a simple, coherent way, citing lessons learned during the collapse of Lehman Brothers. Messy booking practices could make it harder for authorities to quickly resolve stricken banks, the BoE fears.

While many firms have improved their structures and controls since 2008, says Megan Butler, executive director of international banking supervision at the BoE, some still have practices that worry the supervisor.

"So, for example, we see firms where the credit risk is booked in the UK entity, market risk is booked in a separate, unregulated entity in a second jurisdiction, and the profit and loss is ascribed to yet another entity," says Butler.

"That's a classic example of something that's overly complex and opaque. It is this sort of thing that we need to shine a light on and simplify over the next few years," she adds.

If there is "no coherent rationale" for a bank's booking structure, the BoE will require it to be simplified, Butler and a colleague warn in an article for Risk, which will be published online on July 7.

It is this sort of thing that we need to shine a light on and simplify over the next few years

The Lehman Brothers failure in 2008 showed that the more complex derivatives booking practices are, the less knowledge there is about the interdependencies of those books. This resulted in worse oversight and made it more difficult to unwind the trades, the article argues - a concern for the BoE because the UK is a significant booking hub for global investment banks.

"Most of these global banks have built up their booking models and businesses over many, many years. They have grown barnacles all over them. They need to understand what they're doing, why they're doing it and where they're doing it. Then we can work out whether there are barriers to effective resolution," says Butler.

She notes that it is in both the regulators' and banks' interest to have simple and transparent booking structures.

A capital specialist at one UK bank agrees, saying that for resolvability purposes and the upcoming European Union rules requiring separation of trading and retail operations, it makes sense to have simple booking structures.

"If there is 'no coherent rationale', then it seems logical to eradicate it. But there may be different views of what is thought coherent," he says.

He points to various regulations that also make simpler booking structures desirable. For instance, the Basel Committee on Banking Supervision's global systemically important financial institution (Sifi) rules - which dictate the size of the Sifi surcharge to bank capital requirements - penalise multiple internal bookings. The rules measure banks across five categories, and intra-group trades count toward the interconnectedness and complexity calculations, which make up 40% of the total score.

Separately, the Capital Requirements Regulation (CRR) – one half of Europe's version of Basel III – imposes limits on the size of the exposures banks can have with individual counterparties, which can include intra-group exposures. Under the current rules, a bank cannot have exposures that are larger than 25% of its own capital base to a single counterparty.

Article 113(6) of CRR allows banks to apply to their home regulators to exempt intra-group entities from its home country from the large exposure limits, but only if there is "no current or foreseen material practical or legal impediment to the prompt transfer of own funds or repayment of liabilities from the counterparty to the institution".

Azad Ali, a counsel at law firm Shearman & Sterling in London, says bank booking structures are not as complicated as regulators may think, as the new capital rules have incentivised banks to keep as few booking centres as possible.

"The more booking centres you have, the more fragmentation of capital and liquidity you have, the more eventual cost there is from a cost of capital perspective, which then gets channelled over to clients and customers," says Ali.