Long stay parking: G-Sibs seek BRRD swap stays exemption

Resolution authorities do not want systemic implications of extended moratorium, say banks

Swaps markets are global by nature, and proposed European Union rules that would fundamentally change the position of a bank’s derivatives counterparties in the event of its failure have inevitably triggered fears over the competitive position of EU dealers.

The rules in question are extended close-out stays on derivatives, proposed under the updated Bank Recovery and Resolution Directive. In plans put forward by the European Commission in November 2016 and supported by the banking union’s Single Resolution Board (SRB), BRRD II would allow regulators to extend statutory stays on derivatives from the globally agreed two-day International Swaps and Derivatives Association contractual protocol to between five and 12 consecutive working days, depending on where the final rules land. A 12-day stay would include a five-day pre-resolution moratorium, five days in resolution and the existing two-day protocol.

“This is a huge own goal for the EU. During the next financial crisis the locus of seizure in interbank credit will be in Europe because of this moratorium. Everyone will know the first place you’re at risk of loss is in the EU, so you could see runs on the bank before regulators step in,” says one US industry source who did not want to be named. “People in the US are looking at this and thinking these Europeans are insane to shoot themselves in the foot like this.”

Swap market participants are lobbying EU lawmakers to exempt global systemically important banks from the proposal. Some are even calling for the exclusion of all financial market contracts, including repos and swaps, entered into by any bank from the scope of the moratorium powers.

Lobbyists argue the SRB would never apply a five-day (or longer) moratorium to a G-Sib under almost any circumstance, given this would undermine regulators’ commitment to the preservation of critical services in resolution. If a large bank were to fail and be subject to an extended moratorium, the systemic impact on other large counterparties, including other G-Sibs, could be enough to escalate a crisis and cause otherwise avoidable failures. 

Elke Koenig, chair of the SRB, has already hinted such powers would not be applied to G-Sibs, saying an extended stay would “trigger questions” from other banks and regulators around the world. She made the comments at a press conference during the SRB conference in Brussels at the end of September, but fell short of suggesting a G-Sib exemption could be applied. 

[Elke Koenig] has said this wouldn’t apply to a G-Sib and I believe her because it would make no sense

London-based lawyer

Bankers and lobbyists say the SRB leadership has told them privately that an extended close-out stay would not be applied to G-Sibs. Instead, regulators have reportedly said this resolution power is intended for smaller regional banks, especially those faced with failure as a result of high non-performing loans, as has been the case for recent bank failures in Italy.

“You speak to Elke Koenig and she says, ‘we don’t really want to use this against big banks – we want to keep this for small deposit banks chock full of NPLs, not BNP Paribas or Deutsche Bank’,” says one London-based lawyer. “She has said this wouldn’t apply to a G-Sib and I believe her because it would make no sense.”

The US industry source details similar comments from the SRB: “Not a board member, but a senior SRB staffer told us: ‘Why are you complaining? This would never be applied to big global banks or financial liabilities you are talking about.’ This is for the other 6,000 banks in Europe that would be resolved largely by national authorities.”

Bob Penn

Koenig has also justified the BRRD II proposal by arguing an extended moratorium is already available under local German law. However, this does not create a problem for swaps and other counterparties to German banks because immediate close-out is permitted, according to Bob Penn, a London-based partner at Cleary Gottlieb. He says the German banking law is superseded by the European financial collateral directive, protecting the status of swaps counterparties. But if an extended moratorium is added to BRRD II at the EU level, this will no longer be the case.

“The stays and other powers under BRRD are not superseded by the financial collateral directive – to the contrary, BRRD overrides the financial collateral directive protections. So if the proposed moratorium powers are added to BRRD, you’re changing from a situation where swaps and repos can be terminated promptly, preserving net capital treatment under the Basel regulatory capital framework, to actually staying termination rights for lengthy periods,” Penn says.

Prepare for the worst

Koenig’s verbal assurances are not enough, market participants warn. Even if counterparties to G-Sibs were convinced the SRB would never apply an extended stay to a globally significant bank, the power would remain on the statute book unless G-Sibs are explicitly exempt as part of BRRD II. This means banks facing EU G-Sibs would have to hold higher capital and margin under the prudent assumption that the worst could happen.

“If the SRB accepts the argument that this won’t apply to the big global banks and it’s only for the smaller banks, which don’t have the same resources to recapitalise, it needs to exclude us from the rule,” says a policy expert at a non-EU G-Sib.

Lobbyists argue that given G-Sibs are required to hold total loss absorbing capacity (TLAC), which will be equal to 16% of risk-weighted assets by 2019, they have enough bail-in capital to resolve a bank quickly without the need for a very long freeze on derivatives close-out. The liquidity provided by the TLAC bail-in should be enough to allow the very quick turnaround of a failing bank and for it to pay its counterparties what they are due.

“Our point was even if the tool is just intended for smaller institutions, because you’ve written it like it applies to everybody, immediately on day one of imposing this as part of BRRD II, this is going to cause all of the negative effects we’ve presented,” says the US source. “I found it incredibly disingenuous for them to say we’re going to write it into the law, but never use it on G-Sibs.”

Although this argument seems to be getting through to the SRB, the US source says he has been told excluding G-Sibs from the stays extension would not be palatable for European lawmakers, given it might end up giving big banks an advantage over small banks.

We hear from regulators supporting the proposal that they don’t expect to apply a moratorium to things like repos and swaps. In that case, they should exempt these contracts

Knox McIlwain, Cleary Gottlieb

“We’ve been told proportionality doesn’t work that way; that proportionality is a concept, which allows smaller banks to avoid some regulation and this doesn’t work in reverse. So, politically, we were told this just isn’t going to happen,” he says.

The alternative would be a carve-out for financial market contracts, based on the fact that shutting down parts of the swaps market in the event of a dealer failure would have potential systemic consequences.

“We hear from regulators supporting the proposal that they don’t expect to apply a moratorium to things like repos and swaps. In that case, they should exempt these contracts. There’s already a definition of financial contracts under BRRD, which includes swaps, commodities, futures and forwards, so it’s there ready to use,” says Knox McIlwain, a counsel in Cleary Gottlieb’s London office.

Some policymakers are said to be considering this approach. But it would also run up against the difficulty that the existing two-day stay would apply mainly to G-Sibs – the dominant swap dealers – while the much longer moratoria on deposits would hit mostly smaller, less complex banks, as well as their small business customers. That seems likely to prove unpalatable from a political viewpoint. “And I’m sympathetic to those political realities,” says the US source.

US capital surge

If G-Sibs are not exempt, banks say there could be disastrous consequences for the competitiveness of EU banks and the willingness of foreign counterparties to trade with them.

A position paper from the US-based Clearing House Association and the Securities Industry and Financial Markets Association (Sifma) at the end of September makes clear than if an extended moratorium goes ahead it will undermine the ability of US banks to net positions for the purposes of calculating capital, margin and liquidity requirements.

This is because US regulators require banks holding contracts with foreign banks to have close-out stays that are “substantially similar” to US rules – which in the US is a one-day stay – in order to net their exposures. As the BRRD moratorium looks set to be at least three days longer than the internationally agreed two-day stay and four days longer than the current US stay, it is unlikely the US regime would consider this anywhere near similar to its own rules.

Given we think the EU stay could be as long as 12 days, US regulators can’t possibly judge this as substantially similar

Policy expert at a non-EU G-Sib

“Given we think the EU stay could be as long as 12 days, US regulators can’t possibly judge this as substantially similar. The consequences are that first, we would have to ask for more collateral from the EU counterparty, making us uncompetitive from their perspective; then, we’d have to treat exposures on a gross basis, which increases our own capital requirements across all prudential rules,” says the policy expert at a non-EU G-Sib.

The ability to net is crucial for US banks in their calculation of the liquidity coverage ratio – because it reduces the potential outflows banks need to be able to cover in a 30-day stress scenario – and for margin period of risk requirements. MPOR is based on the time expected to pass between the last exchange of collateral with a defaulting counterparty and the time at which it can close out or liquidate its portfolio. Currently, MPOR is based on the assumption of a 48-hour stay in most cases, meaning a five- or 12-day stay would significantly increase the amount of initial margin required of parties to post.

Knox Mcllwain

“The result would be that for US entities facing EU entities, it could be prohibitively expensive to enter into swaps and repo contracts. This would also be true for the US operations of certain EU banks – their transactions with their EU affiliates would be treated the same way. We just have to hope this isn’t going to happen,” says Cleary Gottlieb’s McIlwain.        

In a global swaps market, what hurts US banks on one side of the trade will hurt EU banks on the other. Concerns for the ongoing competitiveness of European banks have been raised in a letter to EU lawmakers from the Association for Financial Markets in Europe (Afme) on October 4, arguing that counterparties are less likely to deal with an institution where they may be “left without the ability to manage market risk or the risk of default through accessing deposits, managing collateral or exercising close-out and/or termination rights for an extended period”.

Additional costs are not exclusive to banking either. One UK lobbyist says it will be the responsibility of prudent end-clients entering a swap contract to choose the bank with the briefest moratorium period in order to close out stays as quickly as possible in a crisis. This means corporates, pension funds and insurers would likely be drawn to signing contracts with US banks, rather than EU banks in future.

“You could have a situation where, within a seven-day period, your mark-to-market position on a contract could shift significantly, but your collateral remains frozen – meaning instead of you owing the bank collateral, the bank owes you collateral. So not only have they got your collateral, but they also owe you collateral,” the lobbyist says.

“Across an entire market we think that would be hugely disruptive, which just isn’t warranted by the resolution authority needing some extra time for [resolving] a single entity.”

Guarded optimism

Despite the political risks of being seen as soft on G-Sibs, there is guarded optimism from banks that EU lawmakers will appreciate the dangers of approving the moratorium proposal in its current form. They may yet turn against this element within the BRRD as it is continues to be debated between the European Parliament, Council and Commission.

The hints perceived by banks echo the views of Roberto Gualtieri, chair of the Parliament’s Economic and Monetary Affairs Committee (Econ), who told Risk.net he thought current plans were “dangerous”.

A September European Council compromise text we reported last month – suggesting a five-day moratorium comprised of a three-day statutory pre-resolution mechanism plus the Isda two-day protocol – tallies with the number of days referred to by Koenig at the SRB press conference in Brussels. So five could be the magic number when the final rules come into force. The problem is that anything significantly longer than the 48 hours agreed internationally is unlikely to satisfy US regulators and allow US banks to net their exposures. 

Lobbyists make the point that increased capital charges for US banks are not going to be the issue that swings the vote against extended moratorium. Rather, if BRRD II in its current form can be shown to increase systemic risk and the likelihood of bank failure, instead of reducing it, this could turn opinion against the rules.

“The application or existence of a stay power is likely to make markets more sensitive to stress as counterparties could be impacted at an earlier stage, potentially destabilising other banks,” argues the Afme letter.

The application or existence of a stay power is likely to make markets more sensitive to stress as counterparties could be impacted at an earlier stage, potentially destabilising other banks

Association for Financial Markets in Europe

Similarly, the US industry source’s suggestion that counterparties will close out their contracts or take their money from an EU bank before stepping away from foreign banks precisely because of BRRD II is a powerful argument.

Another ace card for lobbyists could be the potential consequences of extended stays on the real economy and consumers. The policy expert at the non-EU G-Sib says applying a long moratorium to a custodian bank – the largest of which are G-Sibs – could undermine the ability of other institutions to pay out to end-consumers.

“I don’t think policymakers have realised the consequences on consumers of freezing the assets of a custodian bank for a long period of time. It could be a bond payment by a sovereign or an old lady on the street who doesn’t get her pension paid,” the expert says.

As arguments move away from the profit-making ability of large banks to the needs of consumers in the electorate, as well as the exacerbation rather than reduction of systemic risk, lobbyists believe their policy concerns will carry more weight.

“The prospect of a moratorium on large deposits could significantly increase the risk of runs on banks in a crisis,” says McIlwain. “And imagine what happens to the economy if companies can’t make payroll or pay vendors for 12 business days.”

Although the lobbyists accept it would be politically difficult to achieve regulatory exemptions for G-Sibs, the many negative consequences of an extended moratorium on the wider European economy may be enough to challenge accepted norms on how the concept of proportionality is applied.