Counterparty Credit Risk Roundtable

Counterparty Credit Risk Roundtable

April 6, 2011
Detailed Outline of Regulatory Framework

Table of Contents

I.Introduction......

A.Financial crisis brought new focus on U.S. and international capital and liquidity regimes, and perceived systemic risks posed by large institutions and activities with the potential to substantially disrupt financial markets.

B.Result......

II.The Orderly Liquidation Authority and Counterparty Credit Risk......

A.Overview......

B.Implementation......

C.Coverage......

D.Treatment of QFCs......

E.Bridge Financial Companies......

F.Treatment of Creditors of Similar Priority......

G.Haircut Study......

H.Use of CCPs......

III.New Capital Burdens......

A.General Capital and Liquidity Burdens......

B.Potential Capital Burdens Specific to Counterparty Risk......

C.Practical Implications......

IV.Limits on the Counterparty Exposure of Banking Institutions......

A.At the Consolidated Entity Level......

B.At the Bank Level......

C.Affiliate Transactions......

V.Dodd-Frank Act and Swap Counterparty Risk......

A.Overview......

B.Capital and Margin Requirements......

C.Clearing of Swaps......

D.Proposed Rule on Financial Resources Requirements for DCOs and SIDCOs

E.Other Dodd-Frank Act Related Swap Counterparty Issues......

F.Absence of International Coordination......

Appendix A: Collins Amendment Phase-in Timeline

Appendix B: Basel III Capital Component and Phase-in Timeline

Authors:

GregoryLyons – 212-909-6566;

Emilie Hsu – 212-909-6884;

1

23275655v6

23400872v1

I.Introduction

A.Financial crisis brought new focus on U.S. and international capital and liquidity regimes, and perceived systemic risks posed by large institutions and activities with the potential to substantially disrupt financial markets.

B.Result: The most significant change in banking law since the Great Depression –

1.Dodd-Frank, which calls for 240 rule-making processes and nearly 70 studies by 11 different regulators, and

2.TheBasel III framework, with higher minimum capital requirements and new conservation and countercyclical buffers, revised risk-based capital measures, a new leverage ratio, and two new global liquidity standards.

3.Some provisions of Dodd-Frank are already effective, but many provisions will become effective on July 11, 2011, or after rules are written.

4.It is impossible now to know the full repercussions of the Dodd-FrankAct and Basel III framework, or their cumulative effect, but some things are (unfortunately) clear.

II.The Orderly Liquidation Authority and Counterparty Credit Risk

A.Overview: Title II of Dodd-Frank provides a framework for the liquidation of certain large financial institutions, the failure of which it is determined would pose systemic risk toU.S. financial stability.

1.In response to the market disarray surrounding Bear Stearns, Lehman Brothers and AIG, the Orderly Liquidation Authority is meant to provide an infrequent alternative to bankruptcy or bail-out, allowing for the quick wind-down of large, interconnected financial companies in an orderly manner.

2.“The resolution process would ensure that there is the necessary liquidity to complete transactions that are in process at the time of failure, thus addressing the potential for systemic risk without creating the expectation of a bailout.” (Testimony of FDIC Chair Sheila Bair, Senate Banking Committee, July 23, 2009)

3.Section 214 of Dodd-Frank provides that all financial companies put into receivership under the Orderly Liquidation Authority must be liquidated; there will be no bail-out. However, the FDIC may create a bridge financial company to continue any or all of the operations of the covered financial institution.

B.Implementation: The Orderly Liquidation Authority is intended to be used rarely, only with firms that are thought to be “too big to fail” and if bankruptcy is deemed to present too much of a threat to the U.S. economy; bankruptcy remains the preferred regime for resolving failed financial institutions.

1.Per Section 203 of Dodd-Frank, triggering the Orderly Liquidation Authority requires:

a.A recommendation by a two-thirds vote of the FRB;

b.A recommendation by a two-thirds vote of the FDIC (or the SEC if the largest subsidiary is a registered broker-dealer; or the FIO if the largest subsidiary is an insurance company);

c.A determination by the Treasury Secretary after consulting with the President; and

d.A review by a federal district court (unless the company consents).

2.Section 209 of Dodd-Frank requires the FDIC (in consultation with the Financial Stability Oversight Council) to make rules and regulations necessary or appropriate to implement Title II; such rules should be harmonized with existing insolvency laws wherever possible.

a.Dodd-Frank gives no time frame for this rule-making; but the first Notice of Proposed Rulemaking was issued October 12. Additional interim and proposed rulemakings were issued on January 25, 2011 and March 23, 2011.

C.Coverage: The Orderly Liquidation Authority may only be applied to nonbank “financial companies.”

1.This is a broad category, extending possibly to broker-dealers, investment advisers, investment banks, and other asset management firms.

2.“Financial company” means:

a.A bank holding company.

b.A non-bank financial company supervised by the FRB (because it has been determined “systemically significant”).

c.Any company that is “predominately engaged” in “financial activities,”[1] that is, under the FDIC’s March 23 Notice of Proposed Rulemaking, if:

i.At least 85 percent of the total consolidated revenues of such company (determined in accordance with applicable accounting standards) for either of its two most recent fiscal years were derived, directly or indirectly, from financial activities, or

ii.Based upon all the relevant facts and circumstances, the FDIC determines that the total consolidated revenues of the company from financial activities constitute 85 percent or more of the total consolidated revenues of the company.

d.Any subsidiary of any of the above(other than a bank or insurance company) that is predominantly engaged in BHC Act Section 4(k) financial activities. (Dodd-Frank Section 201(a)(11))

3.Liquidation of covered financial companiesadministered by:

a.FDIC – All covered financial companies other than broker-dealers and insurance companies.

b.SIPC (to be appointed liquidation trustee by FDIC)–registered broker dealers.

i.SIPC must conduct a liquidation in accordance with SIPA; but the rights and obligations of any counterparty to a qualified financial contract (“QFC”) (discussed below) will be governed exclusively as provided by Section 210 of Dodd-Frank, notwithstanding any contrary SIPA provision.

c.If an insurance company is a covered financial company (or subsidiary or affiliate of a covered financial company), its liquidation will be conducted under state law.

4.Insured depository institutions are not covered financial companies; liquidation of insured depository institutions is governed as provided under the Federal Deposit Insurance Act.

5.A registered mutual fundis not deemed a subsidiary of a covered financial institution unless the institution (together with its affiliates) owns 25% or more of the interests in the fund.

D.Treatment of QFCs: Dodd-Frank prescribes the rights of counterparties to certain QFCs with the covered financial company.

1.Any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the FDIC determinesis a QFC under Section 210(c)(8)(D) of Dodd-Frank.

2.IpsoFacto Termination Rights – Limited Stay (Dodd-Frank Section 210(c)(10)(B))

a.Once the FDIC has been appointed receiver:

i.parties to QFCs may not exercise termination rights triggered by the appointment or the insolvency or financial condition of the covered financial company – so-called “ipso facto” clauses:

(1)until 5:00 p.m., Eastern time, on the business day after appointment; or

(2)if earlier, after receipt from the FDIC of notice of transfer of the QFC to a bridge financial company or other financial institution that is not the subject of an insolvency proceeding.

b.Similarly, contracts entered with subsidiaries of the covered financial institution that are guaranteed by the covered financial institution may not be terminated based on the insolvency or receivership of the covered financial institution, provided the guarantee is transferred to a bridge financial company or other entity. (Dodd-Frank Section 210(c)(16))

c.The exercise of other termination rights not triggered by ipso facto clauses are not stayed.

d.Drafting has left some ambiguity in the scope of the stay, which applies to termination rights exercisable “solely by reason of or incidental to” the appointment of the FDIC as receiver or insolvency or financial condition of the covered financial company.

i.For example, would a termination right triggered by a failure to post additional collateral upon a ratings downgrade be stayed as “incidental to” the financial condition of the covered financial company?

3.Limited Suspension of Obligations (Dodd-Frank Section 210(c)(8)(F))

a.Payment and delivery obligations of the non-covered financial company under a QFC are suspended until the earlier of:

i.5:00 p.m.,Eastern time,on the business day after the appointment of the FDIC as receiver, or

ii.Receipt from the FDIC of notice of transfer of the QFC to a bridge financial company or other financial institution that is not the subject of an insolvency proceeding.

b.Any “walkaway clause” –a provision suspending or excusing performance by the non-covered financial company as the non-defaulting party under a QFC triggered by the appointment of the FDIC as receiver or insolvency of the covered financial company – is unenforceable.

4.Section 210(c)(1) of Dodd-Frank provides that the FDIC may repudiate contracts if it determines that:

a.Performance under the contract would be burdensome, and

b.Repudiation would promote the orderly administration of the company’s affairs.

c.In exercising its right to repudiate QFCs, the FDIC shall either repudiate all or none of the QFCs between any person (or such person’s affiliate) and the covered financial company. (Section 210(c)(11))

d.Compensatory damages for repudiation of QFCs will be determined as of the date of the contract’s repudiation; they include normal and reasonable costs of cover, but not damages for lost profits. (Section 210(c)(3)(C))

E.Bridge Financial Companies

1.Section 210(h) of Dodd-Frank authorizes the FDIC to organize a bridge financial company (a “Bridge”) to continue to operate potentially systemic operations of the failing firm, to prevent a disorderly collapse.

2.As a general matter, the Bridge may assume liabilities and purchase assets of the covered financial company at its discretion.

3.The FDIC may transfer to the Bridge (or to another financial institution that is not itself under receivership; if such other institution is a foreign entity, rights with respect to QFCs must be substantially the same as under Dodd-Frank) either all or none of:

a.The QFCs between any person (or such person’s affiliate) and the covered financial company;

b.All claims of the person or the covered financial company under such QFCs (other than claims that are subordinated under the terms of the contract to the claims of unsecured creditors); and

c.The property securing or any other credit enhancement with respect to such QFCs. (Dodd-Frank Sections 210(a)(1)(g); 210(c)(9)(A))

d.Note: per informal discussions with FDIC staff, all QFCs are likely to be transferred to the bridge as a practical matter.

4.Although the FDIC must treat similarly situated creditors similarly in exercising its authority to transfer assets and liabilities to a Bridge, it may do otherwise if necessary to maximize the value of the assets of the covered financial company or maximize the value or minimize the loss from the sale or other disposition of assets.

5.If the FDIC establishes a Bridge with respect to a covered broker dealer, it must transfer all customer accounts of the broker dealer and all associated customer name securities and customer property, unless such accounts and property are likely to be promptly transferred to another registered broker dealer, or the transfer would materially interfere with the FDIC’s ability to avoid or mitigate serious adverse effects on the U.S. economy. (Section 210(a)(1)(O))

6.Financial institutions are being encouraged – and in the case of systemically significant institutions and bank holding companies over $50 billion, required – to design “Living Wills” to guide the FDIC in its exercise of its Orderly Liquidation Authority in the event the institution fails; Living Wills could help to determine which operations are appropriate for transfer and eventual sale, rather than liquidation.

a.By July 21, 2012, the primary federal bank regulators must prescribe regulations requiring that financial companies maintain records with respect to QFCs that would assist the FDIC as receiver in the performance of its obligations with respect to QFCs.

b.FDIC proposed Living Wills rules on March 29, 2011; comments due 60 days after published in Federal Register.

c.For those required to comply, Living Wills due July 21, 2012.

i.134 estimated “covered entities.”

ii.Resolution Plan and Credit Exposure Report.

7.Creditors that are counterparties toagreements that have been transferred to a Bridge will be able to enforce and terminate the contracts in accordance with their terms, except that, as noted in II.D.3.b above, walkaway termination rights for QFCs based on the insolvency of the covered financial company will be unenforceable at the FDIC’s discretion.

a.SIPC, as liquidation trustee of a broker-dealer that is a covered financial institution, will not have any powers or duties with respect to assets and liabilities transferred by the FDIC to a Bridge.

b.The FDIC’s March 23 Notice of Proposed Rulemaking (Section 380.26) suggests that contracts purchased or assumed by the Bridge cannot later be rejected by the Bridge.

8.Creditors that are counterparties toagreements that have not been transferred to the Bridge will be at greater risk.

a.The FDIC’s March 23 Notice of Proposed Rulemaking provides that if the FDIC as receiver sells or transfers an asset free and clear of a setoff right that would otherwise be recognized under section 210(a)(12)(A), the party with the setoff right will have a claim in the amount of the “value” of the setoff established as of the date of the sale or transfer of the asset and the claim will be paid prior to any other general or senior liability of the covered financial company. In the event that the setoff amount is less than the claim, the balance of the claim will be paid at the otherwise applicable level of priority for the claim.

b.The FDIC could determine to repudiate any contract to which the failing firm is a party within a “reasonable time”; repudiation would not permit the avoidance of a perfected security interest in the assets of the failed company (such as collateral received in a securities lending transaction).

i.Section 210(c)(1) of Dodd-Frank provides that the FDIC may repudiate contracts if it determines that:

(1)performance under the contract would be burdensome, and

(2)repudiation would promote the orderly administration of the company’s affairs.

ii.The FDIC’s liability for repudiated contracts generally is limited to actual compensatory damages, determined as of the date of the appointment of the FDIC as receiver.

iii.The FDIC’s January 25 Interim Final Rule (Section 380.4(b)) provides that damages for repudiation of a covered financial company’s contingent obligation shall be no less than the estimated value of the claim as of the date the FDIC was appointed receiver, as measured based on the likelihood that the claim would become fixed and the probable magnitude thereof.

9.Thus,e.g., if a borrowerwere put in liquidation and securities loans repudiated, the indemnity for counterparty credit risk provided by agent lenders for counterparty credit risk would apply, and if this were to occur in the context of a broader market crisis, agent lenders could be saddled with illiquid collateral, insufficient to cover the indemnification.

a.To the extent a borrower posts securities as collateral in a securities lending transaction, the securities lending agent, unable to close out a securities lending transaction with a defaulting borrower, would bear any liquidity risk associated with illiquid collateral.

b.An agent lender would be an unsecured creditor of the borrower to the extent of a collateral shortfall.

F.Treatment of Creditors of Similar Priority

1.Section 210(b)(5) of Dodd-Frank provides that the priority structure will not affect secured claims, except to the extent a creditor is under-secured.

a.The FDIC’s March 23 Notice of Proposed Rulemaking provides that in the case of a claim secured by property of the covered financial company, the FDIC as receiver shall determine the amount of the claim, whether the claimant’s security interest is legally enforceable and perfected; the priority of the claimant’s security interest, and the fair market value of the security interest. The portion of the claim that exceeds an amount equal to the fair market value of the property will be treated as an unsecured claim.

b.The FDIC’s January 25 Interim Final Rule provides that collateral for secured claims will be valued at fair market value as of the date the FDIC was appointed receiver of the covered financial company.

c.The FDIC’s March 23 Notice of Proposed Rulemaking provides that the FDIC as receiver may sell property of the covered financial company that is subject to a security interest. In the event that the FDIC sells collateral, the purchaser of the property would take free and clear of the security interest, and the security interest would attach to the proceeds of the sale, up to the allowed amount of the secured claim.

d.The FDIC’s March 23 Notice of Proposed Rulemaking provides that the FDIC as receiver may pay the secured creditor the fair market value of the property subject to a security interest up to the amount of the secured claim in full, and retain the property free and clear of the security interest.

2.Under Section 380.21 of the FDIC’s March 23 Notice of Proposed Rulemaking, unsecured claims have priority in the following order:

a.Repayment of debt incurred by or credit obtained by the FDIC as receiver for the covered financial company, provided that the FDIC as receiver has determined that it is otherwise unable to obtained unsecured credit for the covered financial company from commercial sources;

b.Administrative expenses of the receiver;[2]

c.Amounts owed to the United States;[3]

d.Wages, salaries and commissions to the extent of $11,275 earned not later than 180 days before the date of appointment of the receiver;

e.Contributions owed to employee benefit plans arising from services rendered not later than 180 days before the date of appointment of the receiver;

f.Any amounts due to creditors who have an allowed claim for loss of setoff rights;

g.Other general or senior liabilities of the covered financial company;

h.Obligations subordinated to general creditors;

i.Wages, salaries or commissions, including vacation owed to senior executives and directors of the covered financial company;