The Financial Stability Board appears to be attempting to move jurisdictions towards establishing a framework, or at the very least some common principles, for winding down the derivatives portfolio of a global bank should it get into serious trouble. By Justin Pugsley.
What is happening?
In June, the Financial Stability Board (FSB) released a 10-page discussion and consultation paper entitled The Solvent Wind-down of Derivatives and Trading Portfolios, which mainly focused on the world’s 29 global systemically important banks (GSIBs), particularly those active in global derivatives markets.
There is already plenty of regulation across the major jurisdictions dealing with the resolution and recovery of banks, including the largest ones. In the US in particular stress tests and so-called living wills sit at the core of the regulatory approach. Alongside the UK, it is also the jurisdiction that has given the most thought to winding down the derivatives portfolio of a large, failing bank. Indeed, the FSB paper borrows heavily from the experiences of these two countries.
Winding down a derivatives portfolio can be tricky given the leveraged nature of these instruments, their sheer number, and the legal and contractual ramifications that surface when a financial institution is going bust. The failure of Lehman Brothers in September 2008 certainly demonstrated that: the legal disputes are ongoing a decade later.
If a huge derivatives portfolio is not wound down properly (and carefully), it could unleash chaos across the financial system with implications for other big banks, who are often the main counterparties. Derivatives create considerable interconnectedness, meaning that there is a contagion risk. It therefore makes sense to have a common approach to dealing with the issue.
Why is it happening?
In its paper, the FSB focuses specifically on the wind-down of derivatives portfolios, which is just one aspect of bank recovery and resolution planning.
GSIBs’ derivatives portfolios span many jurisdictions, which can create complications when things go wrong. What the FSB is trying to do with its paper is to explore the possibility of harmonising the approach different jurisdictions take in winding down the large and complex derivatives portfolio of a failing GSIB while causing minimal disruption to the global financial system.
Arguably, it is also an effort to address some of the regulatory fragmentation that has been developing in recent years as jurisdictions take their own approaches and put national interests first. Global standard setters see this as a potential threat to financial stability.
What do the bankers say?
In principle, bankers welcome moves that reduce duplication and make their resolution planning easier. At the moment, there appears only to be mild concern that the FSB’s discussion points might evolve into greater prescription, adding rules and attempting to over-harmonise. They argue that some flexibility must remain in recognition of factors peculiar to each jurisdiction which must be accounted for. But so far no alarm bells are ringing: after all, at only 10 pages long, the FSB report is taking a very elevated view at this stage.
Besides, there are limits as to how far such a resolution framework could go. Individual countries are not going to harmonise their bankruptcy regimes any time soon. Even the EU, with all its centralised institutions, cannot seem to harmonise the bankruptcy regimes of its member states.
Will it provide the incentives?
This is only an initial consultation by the FSB, which may lead to more work and a comprehensive framework for resolving GSIB global derivatives portfolios in the future. Progress will depend on the appetite of FSB’s members to see it come to fruition.
However, if a global resolution framework for GSIB derivatives holdings is ever rolled out, one that sets minimum standards, implements more regulatory co-operation, spreads best practice and establishes common protocols, then that can only be beneficial, given the global nature of derivatives markets.
It would mean that if a GSIB ever failed, regulators could take a more co-ordinated approach to resolving the bank’s derivatives portfolio and act more quickly (time is of the essence in these situations), which overall would help make the global financial system safer.
