This article is part of the PLC Global Finance September 2010 e-mail update for the United States.
While the regulation of the over-the-counter derivatives market required by the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act has received a great deal of attention, other less-discussed provisions of the legislation impose additional restrictions on the treatment of derivatives as extensions of credit by banks where the bank is subject to counterparty credit risk. This article outlines these changes and their likely implications. The changes will come into effect over the next few years.Close speedread
While the regulation of the over-the-counter derivatives market required by the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act" or the Act, P.L. 111-203 (21 July, 2010)) has received a great deal of attention, other less-discussed provisions of the legislation impose additional restrictions on the treatment of derivatives as extensions of credit by banks where the bank is subject to counterparty credit risk.
When effective, these changes will likely require significant revisions to banking organisations' risk management systems for derivatives in particular, and credit exposures generally, and might result in a decrease in derivative volumes over time.
Single-borrower lending limits
Banks in the US historically have been subject to limits on their total loans to a single borrower. Swaps and similar derivatives have not been included in the single-borrower lending limit for national banks. The Act amends the lending limit for national banks to include:
[A]ny credit exposure to a person arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction between the national banking association and the person…. (Dodd-Frank Act, § 610(a), amending 12 U.S.C. § 84(b)(1)).
This provision is effective one year after the "transfer date", which is 21 July 2011 (one year after enactment of Dodd-Frank) or a later date, up to six months later, to the extent that the Secretary of the Treasury grants additional time to transfer the Office of Thrift Supervision into the OCC (the "Transfer Date"). There are various ambiguities attendant to the inclusion of derivatives under the national bank lending limit. The term "credit exposure" is not defined, so apparently it will be left to the OCC to provide a definition. How to calculate the amount of credit exposure will be a key element in understanding the impact of this provision.
Banks chartered under State law are not subject to national bank lending limits but rather the limits set by each State. However, the Dodd-Frank Act requires the States to include derivative exposures in their calculation of lending limits, or their banks will be disallowed from entering into any derivatives at all. It provides that a State bank insured by the Federal Deposit Insurance Corporation (FDIC) may engage in a derivative transaction, as defined in the provision applicable to national banks discussed above, "only if the law with respect to lending limits of the State in which the insured State bank is chartered takes into consideration credit exposure to derivatives transactions." Thus, unless State law in some way provides for consideration of credit exposure from derivatives, the banks chartered by that State cannot enter into derivatives. Effectively, this imposes on each State a requirement to assure that its law on lending limits complies with this provision.
New exposure limit
The Act requires that the Fed issue regulations prohibiting systemically significant bank holding companies and non-bank financial companies from having credit exposure to any unaffiliated company that exceeds 25 percent of the company's capital and surplus; this limit may be set at a lower amount by the Fed if the it determines a lower amount "to be necessary to mitigate risks to the financial stability of the United States". Included in the definition of "credit exposure" for this purpose is "counterparty credit exposure to the company in connection with a derivative transaction…" Again, "credit exposure" in this context is undefined.
This provision is effective three years after the date of enactment, or 21 July 2013, and may be extended by the Fed for two additional years.
Section 23A of the Federal Reserve Act (Section 23A) imposes significant limitations on transactions between a US FDIC-insured bank and its affiliates. Generally, it requires that certain transactions between a bank and an affiliate, called "covered transactions", such as extensions of credit by the bank to the affiliate and purchases of assets by the bank from an affiliate, comply with quantitative and qualitative limits. A bank can engage in covered transactions with any one affiliate only up to 10 percent of the bank's capital and surplus, and may do so with all affiliates in the aggregate only up to 20 percent of capital and surplus. In addition, certain covered transactions, such as extensions of credit, must be fully collateralised.
In 2002, the Fed determined that a bank may enter into a derivative transaction with an affiliate without being considered a covered transaction, effectively exempting derivatives transaction between a bank and its affiliates from Section 23A limits. The Act reverses the Fed's earlier decision. It includes within the definition of "covered transaction" any derivative transaction, using the national bank definition provided above, with an affiliate "to the extent that the transaction causes a [bank] to have credit exposure to the affiliate." As with the national bank provision, there is no statutory definition of "credit exposure". This amendment is effective one year after the transfer date. Accordingly, it comes into effect some time in the second half of 2012.
Implications of derivatives as covered transactions
The Section 23A amendment could have a serious effect on the manner in which major banking organisations centrally manage their derivatives businesses. The 10% limit would likely constrain a bank's back-to-back derivatives with a non-bank that serves as the central management point depending on the Fed's definition of "credit exposure". Also, such an exposure would have to be collateralised under existing Section 23A requirements. Conversely, if a bank is the central management point, the 20% limit would likely constrain its back-to-back derivatives with all affiliates.
Impact of the Section 23A amendment on the Volcker Rule
The Act's so-called Volcker Rule generally imposes a prohibition on banks and bank holding companies from engaging in proprietary trading and in sponsoring and investing in private equity and hedge funds. It has a provision that incorporates the definition of "covered transaction", as used in Section 23A, in order to severely restrict the relationship between the bank holding company and certain private funds.
Under the Volcker Rule, a bank holding company is prohibited from "sponsoring" a private equity or hedge fund with specified exceptions, but not from advising such a fund sponsored by a third party. As to an advised fund or a permissible sponsored fund, the bank holding company and its affiliates are disallowed from entering into a transaction that would be a covered transaction under Section 23A with the fund, treating the fund as though it were an affiliate and the bank holding company (and all affiliates) as though they were banks. That is, the bank holding company and all of its subsidiaries are treated as though they are a "bank" subject to Section 23A, and the fund is an affiliate of the "bank".
This prohibition has a number of implications and difficult interpretive issues that will need to be addressed in rulemaking. However, for this purpose the important point is that, with the addition of derivatives to Section 23A and this new prohibition being keyed off of such coverage, a bank holding company that sponsors or advises private equity or hedge funds will be prohibited from entering into at least some derivatives with any such fund. As a result, such funds may be forced to obtain at least some derivatives from third parties.
The Volcker Rule becomes effective no later than two years after enactment, and then there is a period of at least two years during which covered entities will have to come into compliance.
The several provisions discussed above will require US and foreign banks subject to their requirements to make significant adjustments to their current compliance procedures and monitoring systems as the provisions become effective. While it might appear that the time periods prior to effectiveness are long enough that planning can be delayed, in practice, the amount of time available to take the necessary actions almost always turns out not to be long enough. It would be advisable for institutions to consider the effects of these provisions on their current operations and begin to plan how to make conforming adjustments. The regulatory process applicable to these provisions will also bear watching.