Crucial days: OTC derivatives and bank capital requirements

April 13, 2010

This is an absolutely crucial time in the debate over the threat posed to corporates by the regulatory proposals for OTC derivatives.  On Friday there are two key events: the DG Markt team in the European Commission has a meeting with representatives from some of the key EU countries – to discuss the EC’s thinking on possible exemptions for corporates from the requirement to enter into central clearing for their transactions; and consultation closes on the EC’s paper on ‘Possible Further Changes to the Capital Requirements Directive” (consultation also closes on the underlying BIS proposals on which the EC work is based).

The significance of the DG Markt internal paper for Friday (although the paper is not available publicly it has been widely circulated over the last few days) is that there is explicit discussion on how an exemption might be presented.  For those of us that have been campaigning for this common-sense approach – so as not to destroy the risk mitigation activities of corporates in Europe – this is a huge step forward and one I welcome.  Although there is considerable concern amongst some corporates that the concept of thresholds [for regulatory intervention to require central clearing] could be intended to ‘catch’ the largest corporates, my own view is that by embracing the concept of thresholds those drafting the legislation and regulators will have to address the fundamental issue of systemic risk.

I have always argued that systemic risk arising from corporate activity is almost entirely mythical and I hope that as thresholds are debated it will be seen just how difficult it is to make a case for such risk – and therefore thresholds will prove irrelevant.  The burden of responsibility for identifying a corporate that is creating systemic risk through its activity in derivatives should lie with the regulators looking at regulated entities – such as the financial products business of AIG.

The consultation documents from the BIS and the EC on capital requirements do not make for easy reading other than by enthusiasts for the technicalities of bank capital measures.  However there is one absolutely fundamental issue and it is this that we will cover in the EACT’s response: it would be foolhardy for the bank regulators to take back what those preparing (and voting on) the regulation of OTC derivatives look likely to concede – that corporates should not have their transactions forced into central clearing.

Put at its most simple, the danger is that the bank capital changes (for the future Basel III) are structured to be so punitive that corporates find it unacceptably expensive to use bilateral OTC derivatives and therefore resort to centrally cleared transactions, with the related huge cash drain arising from the provision of cash collateral.  The challenge – and not one to be under-estimated – is to persuade the BIS and the EC to pull back from their proposed approach.

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