BOE Seeks Derivatives Pact to Prevent a Repeat of Lehman Cascade

Photographer: Simon Dawson/Bloomberg

Pedestrians walk past the Bank of England in London. Close

Pedestrians walk past the Bank of England in London.

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Photographer: Simon Dawson/Bloomberg

Pedestrians walk past the Bank of England in London.

The Bank of England is seeking a global pact among banks to suspend default clauses in some derivatives contracts during a crisis, in a bid to ward off bank death spirals that cascade through the financial system.

The U.K. central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BOE’s special resolution unit, said in an interview.

“The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults,” Gracie said. “You would get what you saw in Lehmans -- huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

Regulators and central banks around the world have grappled with banking reforms aimed at keeping public money safe during a financial crisis, since the fall of Lehman Brothers Holdings Inc. in 2008 prompted governments to prop up failing lenders to prevent economic disaster.

The Financial Stability Board, which brings together regulators and central bankers from the Group of 20 nations, has ranked banks and insurers by their potential to cause a global meltdown and demanded bigger financial cushions to avert a repeat of the 2008 credit freeze.

The G20 has also drawn up guidelines aimed at harmonizing the powers available to regulators to wind down a crisis-hit bank.

Own Jurisdiction

Resolution authorities are regulatory bodies with legal powers to unwind a bank and impose losses on creditors. They have powers to enact derivatives stays in a crisis only in their own jurisdiction.

The BOE and other international regulators are “dealing with firms that are global,” Gracie said. “So what we are trying to do is get an ISDA protocol adopted by the banks and their major counterparties which replicates this statutory stay in contractual form.”

ISDA declined to comment beyond a statement published on its website in November.

“Developing such a provision that could be used by counterparties will continue to be a primary focus of our efforts in this important area of regulatory reform,” ISDA said in the statement. “We are committed to working with supervisors and regulators around the world to achieve an appropriate solution that will contribute to safe, efficient markets.”

A global agreement on stays in derivatives contracts is one of several policies the FSB, which is chaired by BOE Governor Mark Carney, is trying to finish before the G20 meeting in Brisbane in November, Gracie said.

Gone-Concern

The central bank is also seeking agreement on a global standard for so-called gone concern loss absorbing capacity, which is junior debt that can be written down in the event of a bank failure, insulating government funds and the wider financial system from the shock.

Banks should ideally have a loss absorbing capacity, made up of subordinated debt and capital, equal to around 20 to 25 percent of their assets weighted for risk, Gracie said.

Debt that can be bailed-in during a crisis will cost banks more to issue, Gracie said, as the implicit government guarantee is removed.

“If it didn’t cost more we wouldn’t have achieved what we wanted because we actually want pricing of liabilities to be risk sensitive,” said Gracie. “We want that to regulate leverage and enforce market discipline on banks.”

Gracie joined the U.K. central bank as a director in 2011, heading up its resolution unit. He began his career at the bank in 1988, before leaving in 2006 to spend five years running his own company, Crisis Management Analytics, advising regulators on bank failure.

To contact the reporter on this story: Ben Moshinsky in London at bmoshinsky@bloomberg.net

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