Banks Face Tougher Capital Rules for Derivatives Under EU Plan

Banks may be forced to hold more capital to protect them from losses on derivatives trades and securities repurchase agreements under European Union proposals.

The possible measures, designed to cut “systemic risk across the financial system,” would also encourage traders to pass derivatives deals through clearinghouses, the European Commission said in an e-mail today.

The financial crisis showed that banks “massively underestimated the level of counterparty credit risk associated with over-the-counter derivatives,” the commission, the 27- nation EU’s executive arm, said. Reviewing how lenders manage these risks “forms an integral part of the commission’s efforts” to “ensure efficient, safe and sound” markets.

The Group of 20 nations is seeking to curb potential risks from OTC derivatives, which are traded directly between counterparties or via brokers. Regulators have argued that more OTC derivatives should be centrally cleared to limit the chances that a bank’s collapse during a derivatives trade could cascade through the economy.

The EU plan follows agreements at international level by the Basel Committee on Banking Supervision, the Brussels-based commission said.

The commission is asking lenders, regulators and investors for their views on different levels of capital that banks should have to hold against possible losses on trades routed through clearinghouses, compared with transactions that aren’t centrally cleared. The groups were given until March 8 to respond.

Government Approval

The agency said it intends to publish draft legislation “before summer 2011.” The measures would need to be approved by governments and lawmakers at the European Parliament before taking effect.

As part of today’s plan, the commission is also considering cutting capital requirements for banks that carry out “an upfront writedown” of the value of derivatives and other contracts to reflect the risk the credit quality of a trading partner could decline.

The Basel committee’s proposed methodology for doing this, published in December 2010, conflicts with current EU practice, the commission said. The Basel plans are subject to an impact assessment that is “targeted for completion in the first quarter of 2011,” the commission said.

To contact the reporters on this story: Jim Brunsden in Brussels at jbrunsden@bloomberg.net.

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net.

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