04 March 2014

Bloomberg: BoE seeks derivatives pact to prevent repeat of Lehman cascade

The Bank of England is seeking a global pact among banks to suspend default clauses in some derivatives contracts during a crisis, in a bid to ward off bank death spirals that cascade through the financial system.

The UK central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BoE’s special resolution unit, said. “The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults", Gracie said. “You would get what you saw in Lehmans - huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

Resolution authorities are regulatory bodies with legal powers to unwind a bank and impose losses on creditors. They have powers to enact derivatives stays in a crisis only in their own jurisdiction. The BOE and other international regulators are “dealing with firms that are global", Gracie said. “So what we are trying to do is get an ISDA protocol adopted by the banks and their major counterparties which replicates this statutory stay in contractual form.” ISDA published a statement on its website in November: “Developing such a provision that could be used by counterparties will continue to be a primary focus of our efforts in this important area of regulatory reform", ISDA said in the statement. “We are committed to working with supervisors and regulators around the world to achieve an appropriate solution that will contribute to safe, efficient markets.”

A global agreement on stays in derivatives contracts is one of several policies the FSB, which is chaired by BoE Governor Mark Carney, is trying to finish before the G20 meeting in Brisbane in November, Gracie said. The central bank is also seeking agreement on a global standard for so-called gone concern loss absorbing capacity, which is junior debt that can be written down in the event of a bank failure, insulating government funds and the wider financial system from the shock.

Banks should ideally have a loss absorbing capacity, made up of subordinated debt and capital, equal to around 20 to 25 per cent of their assets weighted for risk, Gracie said.

Debt that can be bailed-in during a crisis will cost banks more to issue, Gracie said, as the implicit government guarantee is removed. “If it didn’t cost more we wouldn’t have achieved what we wanted because we actually want pricing of liabilities to be risk sensitive", said Gracie. “We want that to regulate leverage and enforce market discipline on banks.”

Full article

© Bloomberg