Clearing House Analysis Finds Flaws in Fed Approach on Credit Exposure Rule

By Borak, Donna | American Banker, July 23, 2012 | Go to article overview

Clearing House Analysis Finds Flaws in Fed Approach on Credit Exposure Rule


Borak, Donna, American Banker


Byline: Donna Borak

WASHINGTON a A proposal to enact strict limits on how much credit exposure the largest banks can have to a major counterparty has significant design flaws that could raise the cost of credit, according to new analysis by The Clearing House.

Large banks have been concerned about the plan since it was released in December, arguing the single counterparty credit risk limit is too strict and would cause them to rebalance their portfolios, reducing the liquidity of the derivatives and securities lending markets.

The Clearing House study is the first attempt to comprehensively quantify the impact the proposal would have. Surveying 13 of the largest commercial banks, the study concludes that the Fed plan would dramatically overstate the level of excess risk exposures.

"One of the key issues around the proposal itself is how credit exposure is measured. The current exposure method in the proposal, or CEM, overstates the underlying risk and we feel that this is not an accurate exposure measurement tool," said Bob Chakravorti, senior vice president and chief economist for the trade group.

The study also analyzed differences in the way the Fed addressed counterparty risk versus its foreign counterparts.

"There seems to be a contrast to what's happening elsewhere such as in the European Union," said Chakravorti. "We should have some consistent global policy."

Under its massive Section 165 proposal, the Fed's plan would require banks with more than $50 billion of assets to adhere to a two-tier structure in how they limit their counterparty exposures.

All such institutions must comply with a Dodd-Frank 25% limit on exposure to a single counterparty, but the Fed has said it may apply a secondary limit of 10% to certain large firms to other major covered counterparties. The limit, which is set at the discretion of the Fed, will depend on the counterparty's size as well as the size of the bank itself.

Such limits are aimed at helping an institution manage its overall risk and avoid significant concentration to any single counterparty. While the industry supports the 25% limit, there is continuing concern about the 10% restriction.

"We would suggest that there should be more quantitative studies done before the 10% limit is implemented," said Chakravorti.

More broadly, the study argues the current exposure methodology the Fed is asking banks to use to calculate their derivative counterparty exposure is significantly flawed. It also disagrees with a requirement to substitute, or "risk-shift," exposures to third-party guarantors on a notional basis.

"Given the large difference between the proposed credit exposure methodology and the methodology being used today for risk management, we would recommend more quantitative analysis be conducted prior to implementation, along with more coordination with the international community," said Chakravorti.

The study claims that the Fed's methodology overstated banks' exposure 12 times more than if the central bank had used a different risk-sensitive internal model methodology, called the IMM, that is widely-used among banks. …

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Clearing House Analysis Finds Flaws in Fed Approach on Credit Exposure Rule
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