Global Business

The Bankruptcy Law and Basel II

One set of provisions in the new law enables cross-product netting of derivative products, but companies may still run afoul of Basel regulators.
Ed ZwirnMay 31, 2005

The effects of the recently passed bankruptcy law on individuals have received widespread publicity; corporate provisions of the new law have been largely overlooked. One set of provisions in the new law — the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, to be enacted October 17 — enables companies to net out transactions between counterparties and across derivative product lines.

Indeed, it modernizes U.S. commercial law by defining derivative products that didn’t exist when the relevant laws were last updated, in the early 1990s. The definitions, contained in Title IX of the act, affect products including repurchase agreements, credit derivatives, energy derivatives, and interest-rate swaps.

“Financial institutions are subject to capital requirement that are often based on the amount of their customers’ obligations to them,” says Marjorie Gross, senior vice president and senior regulatory counsel at the Bond Market Association. The ability to “net all the IOUs and ‘UO Me’s’ so that there’s just one number” on which to base capital requirements can free up enormous amounts of cash, she observes.

Take the instance of the reserves a bank must hold in case a counterparty goes belly-up; the counterparty owes the bank a total of $100 million for various derivatives, while the bank owes the counterparty $60 million. Since under current law the definitions of many of these derivatives are, at best, hazy, the bank’s legal department opines that the bank has no solid legal basis to net out the obligations, and so the bank must hold some percentage of the $100 million in reserve. Under the new law the bank will be able to net out the $60 million against the $100 million, so it will need to reserve only some percentage of the remaining $40 — almost certainly a much smaller amount.

To be sure, smaller revisions have been inserted into the bankruptcy laws in the recent past. However, just as commercial law has redefined itself slowly in the face of rapid technological innovations during the past 10 or 15 years, bankruptcy law has also lagged behind the products and practices developed by finance professionals.

While the definitions in the new law will arguably free up capital by allowing U.S. financial institutions to proceed with cross-product netting, this effect runs counter to the provisions of the Basel II Capital Accord. Basel II — an international attempt to update banking regulations and, in the process, align capital-reserve requirements more closely with risk — would reward banks that use an “advanced approach” to risk measurement by lowering their capital-reserve requirements. (Earlier this month the four U.S. banking agencies announced that they will delay the publication of new rules related to Basel II.)

Basel II’s lower capital-reserve requirements, however, are attainable only in the face of a much more restrictive approach to netting. Regulators from the Basel group and from the International Organization of Securities Commissions would impose a slew of requirements — concerning written netting agreements, prohibitions on walkaway clauses, and alignment with historical industry practices — that may create insurmountable hurdles to the practice, according to critics.

“In the new environment we all want to operate using the provisions of cross-product netting,” said Sharmini Mahendran, executive director of Morgan Stanley’s law division, at a seminar held last week by the Bond Market Association and the International Securities Dealers Association. “It’s not up to these regulators to be telling us from Mount Olympus” to restrict cross-product netting when “under the new bankruptcy law in the U.S. we have the means to do it.”

Looking ahead this week:

• The Financial Accounting Standards Board will again take up the question of whether credit standing and derivative liabilities should be included in the accounting treatment of derivatives under FAS 133 (see “Should FAS 133 Be ‘Marked to Market’?“). Should the board formally add this project, it will also discuss whether its guidance should be in the form of a FASB staff position.

• The board will discuss whether to consider the effect of changes in a debtor’s creditworthiness in reporting liabilities at fair value when the fair-value option has been elected.

• FASB will continue its discussion of the Fair Value Measurement exposure draft and is expected to clarify certain earlier decisions regarding blocks and disclosures.

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