Derivatives pose thorny problem for banks, regulators in resolution plans

By Kyle Campbell

Federal regulators want large banks to get specific about their contingency plans for their derivatives holdings. The Federal Deposit Insurance Corp. and the Federal Reserve cited four of the country’s largest banks last week for weaknesses in their resolution plans related to derivatives — a broad and varied market of financial contracts that include swaps, options and futures. The move was the latest and most direct move by the agencies to encourage banks to step up their practices around the handling of these contracts…Yet because of their complexity and the role they play in financial markets, derivatives receive different legal treatment than other assets on a bank’s balance sheet, said Karen Petrou, managing partner at Federal Financial Analytics. Deemed “qualified financial contracts” by Dodd-Frank, derivatives held by systemically large banks — known as “covered entities” — are shielded from typical default provisions in cases of failure. This means that, unlike in a traditional bankruptcy process, when these banks fail, their counterparties cannot simply close out their derivative positions. This arrangement is meant to protect banks, the FDIC and broader financial stability by mitigating losses for large failed banks and preventing counterparties from having to quickly seek out hedging alternatives.But, because these contracts are treated differently under the special resolution regime than they are under the traditional bankruptcy code, Petrou said there is ambiguity and confusion about how they should be handled.”Without clarification of the bankruptcy code, this is a particularly thorny area for resolvability,” she said. “And there’s only so much the banks can do about it because there is a fundamental statutory confusion.”