Aug 12, 2019

Why It’s So Difficult to Amend Inter-Affiliate Initial Margin Rules

Thomas Hoenig Distinguished Senior Fellow

The largest banking groups in the United States are seeking to roll back some of the regulatory standards the Dodd-Frank Act put in place following the crisis of 2008. In response to these pleadings, regulators are exploring alternatives that might provide regulatory relief that would not also compromise the stability of the industry or the economy.

A proposal currently under consideration would eliminate rules requiring banking groups to post what’s called “initial margin” (IM) collateral for derivative swaps contracts when exchanged among affiliate firms within the same corporate bank group. 

Generally, IM collateral is required when one party writes a contract to another (called a counter-party) for delivery of an asset at a future date. The party writing the contract usually requires some amount of collateral be provided to protect it from loss should market prices turn against the counter-party.  One way to think about IM collateral is as if a loan were written and the lender required collateral to protect it from loss should the borrower default.

Matters get more complex for a banking group that wishes to manage its risk by transferring the different derivative contracts and collateral among its member affiliates. From an overall corporate perspective, it may be advantageous for the corporation to transact to move the swap contract to another affiliate without also moving the collateral as it balances the group’s overall risk and cost profile. From a regulatory perspective, however, an important aspect of such action is that the effect of the transaction reduces costs while not increasing risk to the bank.

This concern arises because the largest commercial banks are more subsidized relative to their group affiliates. The largest banks have FDIC deposit insurance, access to significant liquidity through the Federal Reserve’s discount window, and are generally recognized as too-big-to fail. This wedge in the market’s functioning changes the landscape for managing corporate risk and return trade-offs involving its book of derivative contracts.

With these large-bank subsidies in place, the group’s profit maximizing options shift as they encourage the group to place the contract risk with the bank and leave the margin collateral with a nonbank affiliate that can take more risk and earn more income by doing so. The difficulty is that should there be loss and the group fail, the taxpayer, through the safety net, shares the loss. 

One way to think about the effects of the subsidy is to again consider the implications of a bank group’s nonbank affiliate making a loan to a third party secured by a certificate of deposit. Should the bank group be permitted to move the loan to the bank but leave the collateral behind to be used by the affiliate to maximize group profits? In other words, should taxpayers subsidize the group’s risk-taking adventures?

Understandably, the banking industry wants to remove the requirement that if the bank acquires the derivative contract, it must also receive IM collateral.  It insists that this rule imposes a competitive burden on prudentially regulated swap entities, and that requiring inter-affiliate IM impedes centralizing and improving its risk management program.  For example, if a bank could be the central manager of contracts and collateral, it could see where there are offsetting exposures from various affiliates and place collateral where it can earn the best return.

A survey by the International Swaps and Dealer Association (ISDA) found that the amount of IM held by those firms to cover inter-affiliate swaps at the end of 2018 was $39.4 billion, which comprised 31 percent of all regulatory IM as of that date. ISDA also found that the amount of IM held to cover inter-affiliate swaps increased by over one third since July 2017. The cost of this increased margin may be passed down to commercial end-users to hedge their commercial risk. 

However, the industry may also be motivated by the advantage of placing the swap contract in the subsidized bank (where the cost of holding that risk is lower) and distributing margin collateral to the uninsured affiliates to obtain higher returns for them. Part of the efficiency gain is really about maximizing the returns from the subsidy. 

Based on the ISDA’s survey, eliminating inter-affiliate IM should also be understood as reducing the bank’s loss-absorbing capacity by $39.4 billion, which places the potential burden on the deposit insurance fund and taxpayer. This is particularly the case if the margined collateral becomes “ring-fenced” within a foreign jurisdiction or by legal requirements imposed on the nonbank. And importantly, this reduction in the bank’s IM collateral likely will not be rebalanced with offsetting increases in bank capital requirements.

While the market is the preferred solution to improving bank performance and accountability, the subsidies designed to protect the industry also change their risk incentives. Eliminating inter-affiliate initial margin rules could indeed enable the largest banking corporation to manage risk, but the proposal needs also to address de facto subsidies and incentives that undermine this objective.

Photo credit: Scott Olson/Getty Images

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