Fed aims to curb banks’ exposure to single counterparties

New rule seeks to prevent domino effect of trouble at one bank triggering multiple failures elsewhere

US regulator and central bank the Federal Reserve has tabled a new rule designed to rein in what it sees as the ‘excessive’ credit exposures that large banking organisations have to single counterparties.

In the Fed’s view, unusually large, single-counterparty exposures – particularly between financial institutions – can “spread financial distress” and undermine stability. If approved, the rule would continue the Fed’s implementation of Dodd-Frank standards.

The proposed measure sets a sliding scale of acceptable exposures, as percentages of tier 1 capital, for three categories of what the Fed dubs ‘systemically important financial institutions’ (SIFIs):

1. A global, systemically important bank (G-SIB) would be restricted to a credit exposure of no more than 15% of its tier 1 capital to another systemically important financial firm, and a maximum 25% of its tier 1 capital to an additional counterparty;
2. A bank holding company with $250bn or more in total consolidated assets – or $10bn or more in on-balance-sheet foreign exposure – would be restricted to a credit exposure of no more than 25% of its tier 1 capital to a single counterparty; and
3. A bank holding company with $50bn or more in total consolidated assets would be restricted to a credit exposure of no more than 25% of its total regulatory capital to another counterparty.

Bank holding companies with less than $50bn in total consolidated assets – including community banks – would not be subject to the measure. However, the Fed is planning to set a range of similarly tailored requirements for foreign banks that work in the US.

To explain to its stakeholders how it has drawn up the proposed rule’s SIFI categories, the Fed has published a complementary white paper. It says: “Single-counterparty credit limits are explicitly designed to limit the threat that a default by a large counterparty could pose to the viability of the creditor.

“In designing such limits, the potential effects of simultaneous defaults by both borrower and lender should be considered.”

It warns: “The threat to financial stability that would be created by multiple SIFI defaults is likely many times larger than the financial stability risk posed by the default of a single SIFI and a single non-SIFI borrower.

“Accordingly, it is appropriate to set the limit on inter-SIFI credit exposures at a stringent enough level to ensure that the risk of multiple SIFI defaults is significantly lower than the risk of a SIFI default paired with a non-SIFI counterparty default.”

Fed governor Daniel K Tarullo said: “This regulation would complement overall capital requirements, which are generally based on the size and nature of a bank’s assets, but do not address the concentration of risk in specific borrowers or counterparties.”

His colleague, board chair Janet Yellen, added: “We are determined to do as much as we can to reduce or eliminate the threat that trouble at one big bank will bring down other big banks.”

Read the Fed’s full white paper here.