Dodd-Frank's Derivatives Rules Will Cost Small Banks, Too

According to the Office of the Comptroller of the Currency, 1,291 insured commercial banks and thrifts reported using over-the-counter derivatives at the end of the first quarter of 2012. Most – 90% or so – are smaller financial institutions, with less than $10 billion in assets.

With the Dodd-Frank Act and other new rules regarding over-the-counter derivatives now being finalized and implemented, the question arises: How will these 1,291 firms be affected? In particular, what impact will the new rules have on the 1,000-plus smaller financial institutions?

More than you might think.

True, most of these rules are directed at swap dealers and major swap participants.  For example, financial institutions with more than $10 billion in assets face mandatory clearing and exchange trading requirements.  According to a final rule from the Commodity Futures Trading Commission, financial institutions with assets of $10 billion or less are exempt from the "financial entity" definition, making them eligible for the "end-user exception" from mandatory clearing and exchange trading.  

However, smaller financial institutions that use derivatives to manage the risk of their businesses still face some important new requirements and need to be aware of how the law may affect their risk management strategies and activities.

For instance, under the CFTC’s proposed margin rule, financial end-users will have to post initial and variation margin subject to a cap on the threshold.  This applies even to financial end-users who are deemed by bank regulators to be "low-risk." A "low-risk" financial end-user is one that does not have significant swap exposures, predominately uses swaps to hedge commercial risks, and is subject to capital requirements by a prudential bank or state insurance regulator.  Insurance companies and community banks are examples.  The "low-risk" categorization is not a function of asset size for purposes of margin requirements. 

Also, a joint proposal by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions covers financial firms including systemically important institutions, but does not distinguish smaller financial firms. Therefore, end-users would be required to post initial and variation margin if this proposal were finalized in its current form. The CFTC and banking regulators issued separate proposed margin regulations in the spring of 2011; neither has been finalized to date.

Another area of concern for financial end-users is the recordkeeping and reporting requirements.  Yet another CFTC rule requires that end-users maintain certain records, provide certain information to swap dealers for reporting to a swap data repository and report information regarding historical and new swaps between their affiliates or with other end-users.

The Dodd-Frank Act and related regulatory rulemakings affect OTC derivatives documentation by either requiring amendments to such documentation or imposing compliance requirements on market participants that must be satisfied by amending such documentation. Many end-users may be counterparties with multiple dealers. This creates significant levels of legal and administrative complexity and the potential for duplication of efforts as firms attempt to comply with the new rules.

In August, my organization, the International Swaps and Derivatives Association, launched the Dodd-Frank Protocol to address these concerns. The Protocol allows swap market participants to simultaneously amend multiple ISDA Master Agreements for the purpose of facilitating compliance with Dodd-Frank regulatory requirements, such as external business conduct rules and six others that were in final form when the Protocol was finalized. The CFTC recently extended the compliance deadline for most of the new business conduct rules from Oct. 15 to Jan. 1.

So while many Dodd-Frank rules regarding OTC derivatives certainly affect large banks, smaller banks also have a dog in this fight. As a result, it is vitally important that all stakeholders, regardless of size or sophistication, continue to voice their concerns with the implementing agencies, Congress and the general public. Affected firms must be proactive to ensure that the new regulatory regime offers them the needed flexibility to manage and mitigate their business risks.

Robert Pickel is the chief executive officer of the International Swaps and Derivatives Association.