New capital requirements possible for tri-party clearing banks

The New York finance lawyer who blogs at Economics of Contempt is predicting the Fed will require the tri-party repo clearing banks, JP Morgan Chase and Bank of New York Mellon, to have enough equity, and enough ready cash or cash-like investments, to withstand the failure of two of their biggest clients.

This would help limit systemic risk in the tri-party market.

Alternatively, if the Fed decides the banks have to withstand the failure of only one large client, that would be less of a safeguard.

This decision is “one of the big remaining wildcards in financial reform,” says Economics of Contempt.

This possible new rule grows out of the Dodd-Frank Act, which says the Fed must establish standards for “financial market utilities” that clear and settle transactions between financial institutions and are “systemically important.” The Financial Stability Oversight Council decides which companies get this special treatment.

The Act also gives these utilities access to the discount window, in essence extending the bank safey net beyond traditional banking just as it did during the crisis.

While theorists debate whether to bring shadow banking under the regulatory umbrella, regulators are doing it.

Economics of Contempt calls financial market utilities the “critical infrastructure of the financial system” and gives a list of who the Financial Stability Oversight Council might include in this category. See the blog.

From the blog:

Yes, I do think that JPM and BNY (the two clearing banks) will be deemed systemically important FMUs. … they’re both obviously systemically important: together, they clear over $1.6 trillion in tri-party repos. For a long time, the big fear didn’t involve one of the big investment banks like Lehman failing, it involved one of the two clearing banks failing (since that would affect all of the dealers that use the bank as their clearing bank).

Moreover, JPM’s margining practices with Lehman were almost comically inadequate. For example, for 3 months JPM allowed Lehman to post about $8bn worth of CDOs, valued at par, as margin. And when JPM later “discovered” that these CDOs were worth significantly less, they hit Lehman with a $5bn margin call. Essentially, JPM had been carrying $5bn of uncollateralized exposure to an obviously faltering investment bank in the Summer of 2008. Given JPM’s obvious systemic importance, there’s no way that kind of thing should be allowed to happen. And that’s why the two clearing banks need to be subject to minimum prudential standards specifically for their clearing functions.

Economics of Contempt says a key issue will be whether the Fed will require these utilities to be able to withstand the failure of one or two of their clients.

Clearly, national regulators differ on whether FMUs should be required to be able to withstand the failure of one or two of their biggest counterparties/members. Whether the Fed goes with a “one failure” or “two failures” test will be extremely important for FMUs like JPM/BNY and the clearinghouses, because a “two failures” test would require them to hold significantly higher capital and liquidity buffers. And since I’m making predictions in this post, I’m guessing the Fed will go with a “two failures” test.

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