At the end of last year, the four primary federal banking regulatory agencies (the Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Office of Thrift Supervision) issued a proposal to amend their capital standards for banks, bank holding companies and savings associations to reduce the risk weighting applied to claims on, or guaranteed by, qualifying securities firms. If adopted, this proposal could have a significant effect on the credit derivatives market.
Current Treatment Of Claims On Securities Firms
Under current capital standards, U.S. commercial banks are required to hold minimum levels of Tier 1 capital and total capital against their assets and off-balance-sheet liabilities, with those assets and liabilities risk-weighted according to categories established by the four agencies. The agencies have adopted these standards under the Basel Capital Accord, which was developed by the Basel Committee on Banking Supervision.
The original accord imposed a 20% risk weighting on claims on banks (for example, loans to banks) incorporated in Organisation for Economic Co-Operation and Development countries and a 100% risk weighting on claims on securities firms and most other nonbanking firms. In April 1998, the Basel Committee amended the Basel Accord to lower the risk weighting from 100% to 20% for claims on or guaranteed by securities firms incorporated in OECD countries, if the firms are subject to supervisory and regulatory arrangements comparable to those imposed on OECD banks. The U.S. agencies have noted that one of the reasons that the Basel Committee amended the Basel Accord was to make it consistent with the treatment of claims on securities firms permitted under the European Union's Capital Adequacy Directive, which is followed by a number of European countries. Until now, the agencies have not proposed to follow this amendment to the Basel Accord.
Proposed Treatment Of Claims On Securities Firms
The U.S. agencies' proposed amendment would reduce the risk weighting applied to claims on, and claims guaranteed by, qualifying securities firms from 100% to 20%. To qualify, a securities firm would be required to be incorporated in an OECD country. A securities firm incorporated in any OECD country other than the U.S. would be required to be subject to consolidated supervision and regulation comparable to that imposed on depository institutions in OECD countries. A securities firm, or parent consolidated group, would be required to have a long-term issuer credit rating, or a rating on at least one issue of long-term (that is, one year or longer) unsecured debt, from a nationally recognized rating agency that would be in one of the three highest investment grade rating categories used by the rating agency.
In order to qualify for the more favorable capital treatment, a U.S. securities firm would need to be a broker-dealer registered with the Securities and Exchange Commission, and would be required to be subject to, and comply with, the SEC's net capital rules, margin regulations and other regulatory requirements applicable to registered broker-dealers. The agencies have noted that U.S. securities firms that have registered with the SEC as over-the-counter derivatives dealers would not be qualifying securities firms because they are subject to a less rigorous net capital rule and are exempt from certain regulatory requirements applicable to fully regulated broker-dealers, including some margin requirements.
Impact On Credit Derivatives
Under Federal Reserve Board guidance on credit derivatives issued in 1996, a bank subject to Federal Reserve supervision that provides credit protection through a credit default swap or option, and that enters into an offsetting credit derivative with another counterparty, may treat the first credit derivative as guaranteed by the offsetting transaction for risk-based capital purposes, and that "(a)ccordingly, the notional amount of the first credit derivative may be assigned to the risk category appropriate to the counterparty providing credit protection through the offsetting credit derivative arrangement, e.g., the 20 percent risk category if the counterparty is an OECD bank." Under this guidance, U.S. banks regulated by the Federal Reserve have been able to risk-weight exposure to OECD-based banks under such credit derivatives at 20%, but have had to risk-weight similar exposure to OECD-based securities firms at 100%, while non-U.S. banks operating under rules under the accord and/or the CAD have been able to risk-weight exposure to securities firms at 20%. The proposed rule would level the playing field between U.S. banks and such non-U.S. banks by permitting U.S. banks to risk-weight exposure to qualifying securities firms under such credit derivatives at 20%.
This week's Learning Curve is by Conrad Bahlke, partner at Weil, Gotshal & Mangesin New York.
