Risk of Banks Dodging Rules Leads to U.S. FDIC Scrutiny

The U.S. regulator responsible for making sure banks aren’t too-big-to-fail is examining whether the biggest firms are shifting trades overseas in a way that may undermine rules designed to prevent a repeat of the 2008 financial crisis.

In recent months, large banks have restructured their overseas transactions in an effort to trade swaps -- contracts blamed for exacerbating the crisis -- outside of rules required by the 2010 Dodd-Frank Act.

That law also gave the Federal Deposit Insurance Corp. the power to take over and dismantle large, failing banks, a job that Vice Chairman Thomas Hoenig said Wall Street may be making tougher by the overseas dodge.

“The risks are pretty enormous,” Hoenig said in an interview, adding that the practice could grow and become a bigger threat. “We have a right to be concerned and should be.”

The FDIC has joined the Commodity Futures Trading Commission in “actively monitoring developments” in the banks’ overseas affiliates and watching for any impacts, Andrew Gray, an FDIC spokesman, said in an e-mail.

As the FDIC and CFTC look at the banks’ restructuring of how they trade derivatives overseas, pressure is mounting for the other bank regulators -- the Federal Reserve and Office of the Comptroller of the Currency -- to make their view of the practices clear. While Hoenig says agencies across Washington need to raise awareness, those front-line supervisors of the biggest banks have said only that the firms can do what they’re doing without getting permission.

Approval Unnecessary

“There is no requirement for a national bank to seek advanced approval or notify its regulator regarding the removal of guarantees of overseas affiliates,” said Bryan Hubbard, an OCC spokesman. Hubbard and Barbara Hagenbaugh, a Fed spokeswoman, declined to comment on whether the agencies are concerned that there could be related dangers to banks’ health.

The strategy the banks have used to sidestep the rules is to remove parent guarantees from affiliates or specific transactions so they can trade in the interdealer market free of many Dodd-Frank restrictions, three people familiar with the transactions said last month. Under CFTC guidelines, overseas affiliates that lack a parent guarantee fall under fewer restrictions than do foreign branches or guaranteed affiliates of U.S. banks.

As a result, the swaps market is fracturing with trades in the U.S. falling under Dodd-Frank and trades elsewhere being subject to local laws. Trades with non-U.S. participants are occurring off of the new Dodd-Frank swap-execution facilities because they are being done by the non-guaranteed subsidiaries, John Nixon, an executive at London-based ICAP Plc, the world’s largest interdealer broker, said at an advisory meeting of the CFTC on May 21.

‘Evasive Activity’

Mark P. Wetjen, a CFTC commissioner, said on May 14 that the agency is reviewing the bank moves and analyzing whether there is “evasive activity under way” that may be subject to rules against sidestepping the 2010 law.

Hoenig said withdrawing parent-company guarantees won’t protect a parent bank if its affiliate detonates.

“They’re clearly tied together,” he said, and that distinction on paper won’t change any behavior in a crisis. “In the market’s mind, you run. You don’t ask from whom, you just run.”

After the 2008 financial crisis, Dodd-Frank meant to curb market risks. A whole section of the law addressed the kind of complex deals that couldn’t be unraveled fast enough during the 2008 crisis, toppling firms such as Lehman Brothers Holdings Inc. and Bear Stearns Cos.

Hoenig’s Options

“If you’re going to increase the risk, I’d like to see more capital. That’s one option,” Hoenig said. “If you’re going to increase the risk, especially if you’re taking it overseas, I’d like you to subsidiarize that. That’s an option.”

When banks last year tried to skirt Dodd-Frank rules for overseas trades, the CFTC responded with a new policy. Three of Wall Street’s largest lobbying groups then sued the CFTC in a case pending in federal court.

Trying to bypass new regulations is understandable from the banks’ perspective, Hoenig said.

“You put a reg in, and the idea is to get around it,” Hoenig said. Still, more opaque derivatives contracts won’t help big banks convince the FDIC and Fed that they would be able to go bankrupt without endangering the financial system, he contends. Under Dodd-Frank, the firms have to file annual plans describing how to safely take them apart, and the regulators have to believe they’re credible.

“We should all be very focused on that,” Hoenig said.

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