Fed Proposes Curbs to Early Termination Rights for Banks

WASHINGTON — The Federal Reserve on Tuesday published a proposal to limit early termination clauses in certain derivatives and repurchase contracts in order to keep banks solvent in the immediate aftermath of failure at the largest bank holding companies.

The proposal would bar global systemically important banks from entering into certain qualified financial contracts that include early termination provisions earlier than 48 hours from notice of bankruptcy. The plan would effectively place a stay on counterparties' ability to call certain derivatives, repurchase agreements, reverse repurchase agreements and certain securities transactions in order to give regulators time to stabilize the failed bank without liquidity draining from the institution.

In prepared remarks before the Fed Board on May 3, Fed Gov. Daniel Tarullo said the proposal goes a long way to ensure that Dodd-Frank's bankruptcy and orderly liquidation provisions can be effectively executed. While the proposal would only apply to the G-SIB holding companies, it would affect a wide swath of contracts with all manner of nonbank entities.

"In approving this proposal for comment and, eventually, adopting a final regulation, we have the opportunity to consolidate the substantial progress made in containing the risks to financial stability that can arise from QFCs," Tarullo said. "Nonetheless, if Congress at some point addresses bankruptcy provisions applicable to financial firms, it could be useful to reconsider the breadth of collateral types that currently are eligible for QFC treatment."

The Financial Stability Board — an international regulatory standard-setting body affiliated with the Group of 20 — recommended in 2011 that member nations take steps to limit the early termination rights of swap counterparties in order to better facilitate post-bankruptcy resolution.

The recommendation came as an outgrowth of the experience of Lehman Brothers' 2008 bankruptcy, where many of the failed firm's derivatives counterparties took advantage of early termination clauses in their contracts to extract payment from the firm even after it had filed for bankruptcy protection. The Fed and the Federal Deposit Insurance Corp. said as early as 2014 that changes to early termination rights "on an industry-wide and firm-specific basis" would be necessary as part of implementing the Dodd-Frank bankruptcy and orderly liquidation regimes.

In 2014, 18 major global banks — including the eight U.S.-based G-SIBs — voluntarily agreed to stay those rights for the longer of one business day or 48 hours after bankruptcy as part of an international protocol brokered by the International Swaps and Derivatives Association. That master agreement — known as the ISDA protocol — was effectively retroactive, affecting nearly every applicable contract both going forward and already in place.

While the Fed's proposal effectively codifies the provisions in the ISDA protocol, it is not itself retroactive. The proposal would, however, allow banks to comply by adhering to the terms of the ISDA protocol, though the protocol includes certain creditor protections not considered in the Fed plan. The Office of the Comptroller of the Currency will issue its own, nearly identical version of the plan that will apply to covered banks.

Industry groups have expressed concern in the past about the possible scope of the proposal. The Managed Funds Association, which represents institutional investors and asset managers, said in a white paper last fall that it objected to the FSB's suggestion, arguing that the suspension of early termination rights amounts to a "taking" and will increase, rather than limit, financial instability in times of stress.

"MFA believes that forcing end-users to waive their Default Rights would be harmful for the markets and the global economy," the white paper said. "Contractual Default Rights are critically important to end-users, particularly during stressed market conditions. Such rights not only allow them to protect their investors and other stakeholders from significant Lehman-like losses of their assets but also preserve the integrity and stability of the world's leading financial markets."

The Fed also proposed its version of the net stable funding ratio — a liquidity rule developed jointly by the Fed, OCC and FDIC that requires banks to demonstrate stable funding over a one-year time horizon. The proposal was first unveiled by the FDIC April 26 and hewed very close to both the Basel III recommendations and the framework of the liquidity coverage ratio, which required banks to hold high-quality liquid assets to cover operations for 30 days.

Tarullo said that the ultimate balance of the LCR and NSFR is between requiring banks to hold additional liquidity for use during a stress event and allowing them to draw on those reserves when such an event actually arrives. He said the comment process should enlighten regulators on how well the proposed rule strikes that balance.

"As with all liquidity regulation, the proposal must require firms to maintain sustainable funding profiles and to avoid inappropriate reliance on central bank liquidity access," Tarullo said. "At the same time it should not incentivize firms to hoard liquidity in periods of stress, rather than to use it to keep the financial system operating."

The Fed will accept public comment on both proposals through Aug. 5.