Proposed Derivatives Rules: Regulators Going Too Far?

Guest Contributor: John Jay, Senior Analyst, Aite Group

The name of the game is derivatives regulation, and financial regulators are asking end users to ante up. While pursuing risk management activities, non-financial firms may be subjected to posting higher collateral requirements with their financial counterparties (i.e., banks) than are currently necessary. In part, these firms use the derivatives markets to manage their balance sheets (e.g., cap interest/commodity expense, change interest rate sensitivity of balance sheet, lock-in projected profits) through hedging and other activities.

U.S. depository regulators have proposed that banks impose greater collateral requirements on those end-user clients whose risk exposures grow risky. Bank regulators have cast a wide net over the over-the-counter (OTC) derivatives markets in the name of minimizing systemic risk. End users have always argued that this would foist excessive costs onto their businesses, thereby diverting capital from useful purposes. Have the regulators gone too far? In the end, do the proposals make sense from the overall perspective of the financial system?

The answer depends on whom you ask.

For starters, banks will have the ability to set the client exposure limits, which means that determining “too risky” is in banks’ hands. Surely creditworthiness will mean different things to different banks. Given a choice, end users will gravitate to banks with easier collateral terms. And in a market-share-grabbing environment, banks seeking to expand their derivatives businesses will do all they can to entice potential clients. To a large extent, this system already exists. Should end users bear the cost of such rational behavior, or should banks ration credit according to their own risk control guidelines and corporate mandates (subject to Dodd-Frank)?

There is an underlying assumption that large banks operate rational risk management systems, which includes their capital markets activities. Swap activity is a part of this. With central counterparty clearing (CCP) and swap data repository (SDR) infrastructures being developed industry-wide to comply with Dodd-Frank, it is presumed that regulators will be able to monitor the risk positions (i.e., gross notionals, net risk exposures, margin accounts, and collateral positions) of large banks (i.e., important financial institutions) like never before. Under this approach, the risk will be mutualized among CCP members to the extent that any of the end-user business is (profitably) offset in the liquid parts of the OTC derivatives market.

It is unclear how requiring corporate end users to ante up brings much to the minimizing-systemic-risk table. In other words, increasing margining costs may bring about nothing more than, well, increased costs across the supply chain, and without any attendant marginal benefits to system-wide risk mitigation.

About Maureen Lowe

President and Founder of Financial Technologies Forum, LLC. Editor-In-Chief of FTF News. Entrepreneur, Jersey Girl that recently returned to Jersey, Loves to Bake, Married to a Kiwi, First Time Mom
This entry was posted in Derivatives, Dodd-Frank, Guest Blog, Regulation, Wall Street and tagged , , , , . Bookmark the permalink.

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