Derivatives pose thorny problem for banks, regulators in resolution plans

Mario Tama/Photographer: Mario Tama/Getty I

NEW YORK — Federal regulators want large banks to get specific about their contingency plans for their derivatives holdings.

The Federal Deposit Insurance Corp. and the Federal Reserve cited four of the country’s largest banks last week for weaknesses in their resolution plans related to derivatives — a broad and varied market of financial contracts that include swaps, options and futures. The move was the latest and most direct move by the agencies to encourage banks to step up their practices around the handling of these contracts. 

Some experts say regulators still have not gone far enough. Mayra Rodriguez Valladares, managing principal of the financial regulatory consulting firm MRV Associates, said the findings show that some banks do not have the personnel or the procedures in place to safely engage in such a critical component of the financial market.

“If you don’t know where these things are housed, if you don’t know how much money you could lose during a period of upheaval and if you don’t know how you can unwind, then you cannot be in this business,” Rodriguez Valladares said. “If you can’t explain, in plain English, to regulators the issues they’re asking you to answer in these living wills then you cannot be in that business.”

Derivatives are bilateral agreements tied to the performance of specific market factors, such as interest rates, commodity prices or foreign exchange rates. 

Regulators flagged derivatives shortcomings with Citigroup Inc., Bank of America, JPMorgan Chase and Goldman Sachs. The FDIC went so far as to call Citi’s weakness a “deficiency,” rendering its overall resolution plan “not credible.” 

“The performance of Citigroup’s resolution forecasting tools and systems demonstrated that the firm lacks the capability to incorporate updated stress scenarios and assumptions, and that ongoing weaknesses regarding data reliability and the firm’s control environment contributed to materially inaccurate calculations of the resources required to execute its preferred resolution strategy,” said FDIC chair Martin Gruenberg in a prepared statement. “This weakness could undermine the feasibility of the company’s resolution plan and requires urgent attention by the firm’s senior management and board of directors.”

The Fed took a less harsh view of the New York-based bank’s plan, deeming it a “shortcoming” rather than a “deficiency” and thus sparing it a full overhaul. Citi, for its part, defended itself by saying that its firm-wide stress testing and resolution planning processes are “rigorous” and its balance sheet “strong.”

In his statement, Gruenberg said the firms examined in the biannual review have improved their performance cycle to cycle. He also noted that the firms have the proper playbooks to handle resolutions in theory, but not the capabilities to implement them in practice.

Rodriguez Valladares, who consults both banks and bank regulators on resolution planning,  said there is a lot to keep track of related to derivatives agreements, including where the contracts are domiciled, the specific provisions of the agreements and the legal regimes under which they operate. 

She said the findings demonstrate that some institutions are not making the investments necessary to keep track of all these moving parts. 

“I see this time and again, with banking clients: They focus on hiring the super quants to model asset allocation, the hotshot traders and the big time lenders because those are revenue-generating people,” Rodriguez Valladares said. “They tend to cut corners when it comes to the people who have to do documentation [and] the people who do risk reporting … because those individuals are just seen as a cost center. They’re not seen as a revenue generator, and that, in itself, is a big problem.”

Globally, there were $667 trillion outstanding over-the-counter derivatives on a notional basis, according to the Bank for International Settlements. Over-the-counter derivatives are those made between two or more entities directly, as opposed to exchange-traded derivatives that are subject to more standardization and are bought on an exchange. The vast majority of those OTC derivatives are interest rate swaps, in which one party effectively benefits when rates rise and the other benefits when rates fall. Such contracts are typically used to hedge risks present in other parts of an entity’s business or portfolio.

Edward Ivey, head of derivatives for the law firm Moore & Van Allen, said most large banks have “flat books” of derivatives, meaning the various hedging positions they take on are offset and are profitable not because they beat the market but because they make incremental profit from the spread. But, he noted, they achieve this balance across a wide range of agreements and must manage it constantly.

Ivey said the recent findings from the Fed and FDIC show that regulators would like to see more granularity in resolution plans and explanations about how such interconnected portfolios could be pulled apart, rather than assuming they could be taken on wholesale by a bridge bank or acquirer. 

“The regulators want to know they’re putting thought into this, because it’s about constantly improving the process — they want to know if there’s some way to improve beyond just planning to transfer the whole book,” Ivey said. “Regulators want to see some thoughtful analysis here, because they are also trying to find the best way to do this.”

Derivatives have been a focal point for regulators since the passage of the Dodd-Frank Act of 2010, which requires large banks to devise resolution plans — also known as living wills — to detail how they would be wound down safely. They have issued guidance around the subject and updated the rules around resolution plans several times during the past decade.

Yet because of their complexity and the role they play in financial markets, derivatives receive different legal treatment than other assets on a bank’s balance sheet, said Karen Petrou, managing partner at Federal Financial Analytics. 

Deemed “qualified financial contracts” by Dodd-Frank, derivatives held by systemically large banks — known as “covered entities” — are shielded from typical default provisions in cases of failure. This means that, unlike in a traditional bankruptcy process, when these banks fail, their counterparties cannot simply close out their derivative positions. This arrangement is meant to protect banks, the FDIC and broader financial stability by mitigating losses for large failed banks and preventing counterparties from having to quickly seek out hedging alternatives.

But, because these contracts are treated differently under the special resolution regime than they are under the traditional bankruptcy code, Petrou said there is ambiguity and confusion about how they should be handled.

“Without clarification of the bankruptcy code, this is a particularly thorny area for resolvability,” she said. “And there’s only so much the banks can do about it because there is a fundamental statutory confusion.”