Derivatives Transparency Is Essential to End TBTF

Thomas Hoenig of the Federal Deposit Insurance Corp. recently highlighted a number of key items left in regulators' agenda to end "too big to fail."

Speaking at the National Association for Business Economics conference in Arlington, Va., Vice Chairman Hoenig particularly emphasized that one of the biggest challenges before regulators is "to assure that the largest, most complicated banks can be resolved through bankruptcy in an orderly fashion and without public aid." Compelling banks to be transparent about their financial derivatives portfolios would go a long way in helping the FDIC and the Federal Reserve achieve this mandate.

Data from the Office of the Comptroller of the Currency shows that just the top four U.S. banks — JPMorgan Chase, Citigroup, Goldman Sachs and Bank of America — have over $210 trillion in notional derivatives exposure, or about one-third of the global total. These banks' exchange-traded derivatives are less than 5% of the whole amount, with the overwhelming remainder being over-the-counter derivatives. Dodd-Frank's Title VII requires that eventually the majority of OTC derivatives transact through swap execution facilities and be cleared through central counterparty. However, that transition only started last year and is expected to last several years.

Dodd-Frank also requires the largest U.S. and foreign bank organizations write their bankruptcy strategy in bank resolution plans known as living wills. Banks, however, are still not fully disclosing key information about their derivatives' portfolios that would be very useful to regulators. And what is disclosed in the living wills is not available to the public. All that the market and even ordinary taxpayers can see is the fluff written in publicly available executive summaries.

Most people who read about derivatives read about the front office, that is, about the traders, salespeople or analysts. Yet, the life cycle of a financial derivative is an opaque labyrinth of processes and documentation. Banks will often transact a derivative with a counterparty. In order to hedge their market risk, they will do a mirror transaction with one of their own legal entities, but in a different country.

Unfortunately, even six years after the crisis, analysis from the Senior Supervisors Group shows banks are still doing a dismal job of monitoring their counterparties. Particularly when derivatives markets are very liquid, it is not unusual that a bank may not know who its counterparty is at all times. Even though banks require a lot more collateral for OTC derivatives than before the crisis, these derivatives and collateral are by no means housed in the same legal entity. Because it can be rehypothecated, banks do not necessarily know where the collateral is.

When Lehman Brothers declared bankruptcy, the market and the media had a chance to see the disarray a financial institution's derivatives processes can cause. Lehman had hundreds of International Swaps and Derivatives Association master agreements that governed thousands of derivatives confirmations with counterparties and with internal subsidiaries.

Due to the opacity in OTC derivatives markets, participants were unaware of the exact credit and market risk exposures of Lehman's derivatives portfolios, how the transactions were valued and the level of counterparty concentration. Lehman's own back office often did not know where confirmation documentation was and risk managers had done a terrible job of measuring the value of collateral.

And Lehman was a much smaller institution than our global systemically important banks now.

The FDIC and Federal Reserve are currently reviewing the living wills of foreign bank organizations in the U.S.

They will evaluate U.S. banks' living wills in the fall. This is a good time to think about the information regulators should demand from all GSIBs.

It would be useful to regulators and the public if banks were transparent about how they measure their derivatives' credit, market and operational risk exposures. Having banks disclose the risk factors in their risk measurement models would help regulators understand if banks are well capitalized for unexpected losses that could arise from derivatives. This information would also be useful if a bank had to be resolved, because regulators would have a better sense of what their derivatives portfolios were worth.

Regulators should also demand more detail from banks about what countries banks book their derivatives and collateral in. Bankruptcy laws of that country will govern the bankruptcy or ring-fencing process.

Additionally, it is important for regulators to find out how many ISDA master agreements and confirmations banks have and the extent of their derivatives' counterparties concentrations. Regulators need banks to disclose how contracts would be fairly terminated and paid in each country, given that we are talking about banks transacting derivatives in multiple jurisdictions. As we saw during the Lehman bankruptcy, banks, like children in a playground, take the good toys with them and leave the broken ones for someone else to clean up.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.