Banks tout break clauses as capital mitigant

Dealers say they are willing to jeopardise client relationships by exercising break clauses that allow trades to be terminated early – and should receive capital relief as a result. But regulators need to be convinced. By Matt Cameron

Imagine a situation in which a small manufacturing company is in trouble. It is struggling to compete with foreign rivals and its borrowing costs are soaring. One of its dealers is in-the-money on some large interest rate swaps it transacted for the company five years ago, and has the option to terminate those trades – which would otherwise run for another five years – forcing the company to find the cash to pay a close-out amount.

In the past, banks have rarely exercised these break clauses. In the future, they say trades will be broken regularly – a consequence of the incoming capital charge for credit value adjustment (CVA), which reflects derivatives counterparty risk. As a result, dealers say they should not have to hold capital to cover the full duration of trades in which breaks are embedded.

“Break clauses need to be taken into account for capital purposes. They are real risk mitigants, and the capital we hold against the trade should reflect their presence,” says one interest rate swaps trader at a UK bank in London.

Of course, it’s not quite that straightforward. While a bank may have the option to terminate a trade early, the decision to do so depends on a host of factors – the probability of the client defaulting over the remaining life of the contract, how valuable the transaction is to the bank, and whether breaking the trade would leave the dealer exposed on other, offsetting transactions. Crucially, it also depends on the bank’s relationship with the company. If, say, the client was a globe-trotting technology firm instead of a small manufacturing company, breaking the trade would be far less likely.

Relationship considerations are what prevented trades being broken in the past, and the head of one bank’s fixed-income division says they should still be seen less as an option to terminate a trade, and more as an option to talk to the client about restructuring – possibly persuading a company to post collateral on a transaction that had previously been uncollateralised, for example. Despite that, some dealers say it is possible to incorporate scenarios in which break clauses are exercised when modelling counterparty exposure, and argue capital relief should be awarded.

Regulators are not convinced – and the issue looks set to become another source of friction between the two camps. “I just don’t think this is something supervisors would allow. Even if these clauses were being exercised more frequently, my supervisory instinct says granting relief will lead to the kind of flexibility that creates unhelpful arbitrage and poor incentives,” says a regulatory source who has been involved in Basel Committee on Banking Supervision discussions on the topic.

He is wrong on one thing: some national regulators say they either already allow capital relief for trades containing break clauses, or are inclined to do so. And one bank – Citi – says it is possible to achieve some degree of capital reduction as a result of the clauses.

In part, that’s because the Basel Committee has not taken a formal position – Basel II, Basel III and the trading book rules known as Basel 2.5 are all silent on the subject. Despite that, the regulatory source says the issue has been discussed – and capital relief was dismissed.

“When we were designing the internal models method back in 2004, it was a conscious decision not to give any recognition to break clauses on the basis that we didn’t think they would be exercised, so there was no appetite for granting relief. This thinking is carried through into Basel III. Yes, the rules don’t make mention of break clauses, but if we were to insert statements to cover every conceivable permutation of what might or might not happen, we would still be drafting the rules,” he says.

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