Two banking regulators approved a final rule Thursday to raise collateral requirements for uncleared swaps.
The Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency finalized the rule, which the agencies said would result in banks posting roughly $315 billion in additional capital.
It would also increase the cost of securitization, as the vast majority of swaps taken out by securitization vehicles are uncleared.
During a board meeting, FDIC Chairman Martin Gruenberg said the rule is an important milestone in moving toward a more stable global financial system.
“Establishing margin requirements for non-cleared swaps is one of the most important reforms of the Dodd-Frank Act,” Gruenberg said. “These margining practices will promote financial stability by reducing systemic leverage in the swaps marketplace, and promote the safety and soundness of banks by discouraging the excessive growth of risky non-cleared swaps positions.”
The final rule was approved unanimously by the FDIC board.
The rule was a joint rulemaking between the FDIC, Federal Reserve, Federal Housing Finance Agency, Farm Credit Administration and OCC, and will tie in with separate but related rules by the Commodity Futures Trading Commission and Securities and Exchange Commission that have not yet been finalized. The OCC adopted the final rule earlier Thursday morning, while the FCA approved the rule earlier in the week. The FHFA and Fed are expected to finalize the rule soon. It is slated to go into effect on Sept. 1, 2016.
The measure requires registered U.S. swap dealers and major swap participants that are also federally insured depository institutions to post a specified amount of collateral – known as margin – to offset the costs of winding down an uncleared swap. Swap dealer and major swap participants are registered with the CFTC and SEC and generally are defined as entities that engage in more than $8 billion in swaps activity per year. The rule would apply to swaps initiated after the effective date and would not be applied retroactively.
Swap dealers covered by the rule would be required to post “initial margin” upon the execution of a swap, determined either using a standardized table or an internal model approved by the entity’s supervising agency. In general, the initial margin requirements would be around 30% greater than the margin requirements for similar cleared swaps. The initial margin can be held as cash, foreign currency, treasuries or certain corporate and municipal bonds. The rule also requires so-called “variation margin” to be posted if the values of a transaction shift over time. That margin will have to be posted in cash.
During the board meeting, FDIC Vice Chairman Thomas Hoenig said that he would have preferred that the rule required more collateral for transactions between affiliates of the same firm. “But he said he supported the final rule because he felt that it would protect taxpayers from the risk posed by uncleared swaps in insured institutions. He also noted that the CFTC and SEC could require nonbank affiliates to post margin as part of their versions of the rule.
“While the system overall would have been best served if banks posted as well as collected margin with their affiliates, much is accomplished with the requirement that the insured bank collect margin,” Hoenig said. “I also recognize that other agencies with jurisdiction over nonbank affiliates could require these firms to collect margin as they finalize their rules on this matter.”FDIC estimates that the rule will result in affected banks and their counterparties posting an additional $315 billion in margin against their uncleared swap positions, assuming they relied on internal models rather than the standardized table. The largest U.S. banks -- including JP Morgan, Citi, Bank of America, Morgan Stanley and Goldman Sachs – would likely account for the majority of that collateral.
Swaps -- also known as over-the-counter derivatives – are a multi-trillion-dollar international market of contracts that allow counterparties to exchange a fixed price or benchmark for a fluctuating one, thus allowing companies to hedge their exposures to changing market process and values. The financial crisis exposed the potential of the previously unregulated swaps market to spread financial contagion from unhealthy companies to healthy ones, most famously in the case of American International Group, which required billions in federal bailouts in 2008 and 2009 because of its exposure to credit default swaps.
The CFTC and SEC established rules requiring certain swaps to be cleared – that is, routed through a central clearinghouse in order to mitigate the potential for one company’s failure to affect the rest of the economy. But certain swap transactions are so unique that they would not have a market outside of the two counterparties and therefore cannot be cleared. Dodd-Frank requires those uncleared swaps to post additional margin in order to reflect the additional risk they pose to the financial system.
The uncleared swap margin rule was initially proposed in 2011 but was revised in 2014 to reflect agreements in the international Basel III accord regarding uncleared swaps margin requirements. FDIC also passed an interim final rule as required by 2015’s Terrorism Risk Insurance Program Reauthorization Act that exempts commercial “end-users” who are engaged in swaps as a bona fide hedge and depository institutions with less than $10 billion in assets, thus curbing the impact on community banks.