Swaps May Help Banks Duck Capital Rules, Data Agency Warns

WASHINGTON — Banks may be using credit default swaps to circumvent capital rules, potentially shuttling risk away from the regulated sector in ways that may pose systemic risk, according to a paper issued Thursday by the Office of Financial Research.

The paper examined bank use of derivatives — commonly known as swaps — to reduce capital requirements for risk-weighted assets. If a bank holds a loan whose creditworthiness is less than pristine, regulators require the bank to hold more capital to offset the risk of default. But banks can pay a third party to assume that enhanced risk on their behalf, essentially outsourcing the risk away from the banking sector.

The potential systemic risk emanating from this practice is substantial, even if the cost of entering into a transaction is proportional to the risk of the underlying loan, the paper said, citing how reliance on credit default swaps contributed to the outsized losses from JPMorgan Chase's 2012 "London Whale" incident.

"Even if real risk transfer is involved, these transactions can pose financial stability concerns by increasing interconnectedness, transforming credit risk into counterparty risk, and obscuring capital adequacy to investors and counterparties," the paper said. "And while bank supervisors have extensive data about banks, they may have less information about the nonbanks who are selling credit risk to those banks and ultimately bearing the risk of loss."

The paper relies on an analysis of publicly available data reported by banks to the Federal Reserve for the fourth quarter of 2014. Those quarterly reports require banks to disclose derivatives that are purchased expressly for meeting regulatory capital requirements, and the paper found that 18 banks did so.

The OFR researchers estimated that -based on certain assumptions, since detailed data is not available — the 18 banks in question were able to improve their capital compliance burden by a median of between 8 and 38 basis points, with one bank potentially realizing a relief of as much as 388 basis points. But the researchers note that without greater clarity, it is impossible to know just how widespread the practice is or how much regulatory capital it is displacing.

"To be clear, without knowing the initial risk weights of the underlying exposures and the risk weight of the counterparty, it is not possible to know exactly how much capital relief a bank is achieving by reducing its risk-weighted assets," the report said. "Additionally, banks can obtain regulatory capital relief through the use of guarantees, which banks do not report."

Regulators have raised concerns about the use of derivatives to reduce capital burdens before.

The Federal Reserve in 2011 issued a supervisory letter highlighting the potential for credit protection transactions to "be inconsistent with safety and soundness" and directing supervisors and compliance officers to watch those transactions closely.

The Basel Committee on Banking Supervision in 2013 also issued a draft consultative document on the "potential for capital arbitrage" posed by derivatives and other credit risk mitigation instruments. That draft document called for the premiums of certain credit risk mitigation products to be assessed a 1250% risk weight based on present value. Those premiums would be exempt from that higher risk weight if the underlying asset faces less than a 150% risk weight, however. To date, the consultative document has not been finalized.