Global Business

Basel II and Cross-product Netting

A new document issued by the Bank for International Settlements may help expand the derivatives market by freeing up regulatory capital of financia...
Ed ZwirnJuly 25, 2005

When the Bank for International Settlements (BIS) proposed guidelines this past April on the treatment of derivatives and other “trading book” issues, those guidelines ran smack up against provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Provisions of the new U.S. law, which takes effect October 17, enable companies to net out transactions between counterparties and across derivative product lines. The affected products include repurchase agreements, credit derivatives, energy derivatives, and interest-rate swaps.

The fly in the ointment, according to industry groups such as the Bond Market Association and the International Swaps and Derivatives Association, is that the BIS provisions — part of the Basel II package of international capital guidelines — take a much more restrictive approach to cross-product netting than do the U.S. bankruptcy law or similar European legislation. True, in May the four U.S. banking agencies announced that they will delay the publication of new rules related to Basel II. However, the BIS guidelines are already affecting investment banks subject to SEC rules governing consolidated special entities, which tend to import the Basel provisions, according to Sharmini Mahendran, executive director of Morgan Stanley’s law division.

A BIS document issued last week may help expand the derivatives market by freeing up regulatory capital of financial institutions that engage in multiple sets of derivative arrangements. “The Application of Basel II to Trading Activities and the Treatment of Double Default Effects” was prepared by a joint working group of the Basel Committee and the International Organization of Securities Commissions, of which the Securities and Exchange Commission is a member. In an apparent nod to the more permissive provisions of the U.S. code (and other, similar national laws), the new Basel II provisions would recognize that regulators “should be able to determine with a high degree of certainty…the legal enforceability of the cross-product netting arrangement under the laws of all relevant jurisdictions.”

Robert Pickle, chief executive officer of the International Swaps and Derivatives Association, says that last week’s BIS release largely answers his group’s concerns: “It recognizes that cross-product netting should be able to proceed, provided you have a legal basis for it.” Pickle isn’t sure, however, of how much they might expand the derivatives market. He acknowledges that the new BIS rules lessen the “regulatory capital” that banks most hold in reserve to receive advanced treatment under Basel II, but Pickle observes that the greater concern is usually the “economic capital” needed by parties and counterparties.

For her part, Morgan Stanley’s Mahendran says that while it is difficult to predict the exact dollar impact of the new provisions, the BIS’s recognition of cross-product netting is “an important tool for reducing systemic risk.” It may have “a significant impact going forward,” she argues, as financial institutions “use cross-product netting agreements with a greater degree of confidence.”

In FASB business, last week the board did not meet in regular session, but on Wednesday it released a so-called milestone draft of Proposed Classification for Single-Component Financial Instruments and Certain Other Instruments. (Though similar in format to an exposure draft, a milestone draft doesn’t offer timelines for comment or propose an effective date.)

The document would help in determining whether a financial instrument should be classified as asset, liability, or equity. One discussion involves mandatorily redeemable common stock, which FAS 150 currently requires to be classified as a liability; the new proposal “would require such instruments to be classified as equity if they meet certain conditions.”

Looking ahead, the board will meet Wednesday afternoon at 1:00 in an abbreviated session. The only item on the agenda so far is a continued discussion of the “conceptual framework” project, its continuing attempt to develop a common set of ideas guiding the development of financial accounting for both FASB and the International Accounting Standards Board. Topics will include “discussion of issues related to the qualitative characteristics of financial information” as well as “management’s stewardship and accountability responsibilities and how those responsibilities relate to the objectives of financial reporting.”