Fed Proposes Limit on Termination Rights in Certain Financial Contracts of Large Banks | Practical Law

Fed Proposes Limit on Termination Rights in Certain Financial Contracts of Large Banks | Practical Law

The Federal Reserve Board (FRB) issued a proposed rule designed to promote financial stability by establishing restrictions on termination and other rights under certain qualified financial contracts (QFCs), including derivatives and repos.

Fed Proposes Limit on Termination Rights in Certain Financial Contracts of Large Banks

by Practical Law Finance
Published on 05 May 2016 • USA (National/Federal)
The Federal Reserve Board (FRB) issued a proposed rule designed to promote financial stability by establishing restrictions on termination and other rights under certain qualified financial contracts (QFCs), including derivatives and repos.
On May 3, 2016, the Federal Reserve Board (FRB) issued a proposed rule, under to Section 165 of the Dodd-Frank Act, designed to promote financial stability by establishing restrictions on termination and other rights under certain qualified financial contracts (QFCs), including derivatives and repos, of US global systemically important banking institutions (G-SIBs).
Under the proposed rule, US G-SIBs and foreign G-SIBs that are US operated would be required to amend certain of their non-US financial contracts to prevent immediate termination of the contract by its counterparty in the event a bankruptcy or other resolution process is initiated with respect to the G-SIB.
This rule seeks to address the risk of a run on a failed G-SIB, and any solvent subsidiaries it may have, caused by many firms terminating their financial contracts simultaneously due to the G-SIB bankruptcy default. These rights are safe harbored in the US and certain other jurisdictions (see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist). If adopted, the rule would essentially compel counterparties to G-SIBs to give up certain termination rights that they have bargained for under these contracts.
The proposed rule would affect bilateral uncleared QFCs, which include contracts governing:
The rules provide the option of adhering to the ISDA 2015 Resolution Stay Protocol or ISDA Resolution Stay Jurisdictional Modular Protocol as an alternative to otherwise amending covered QFCs to bring them into compliance with these requirements (see Legal Update, ISDA Launches Resolution Stay Jurisdictional Modular Protocol).
G-SIBs use QFCs to conduct a large volume of transactions and, therefore, mass termination of a G-SIB's QFCs could:
  • Cause the disorderly unwind of the G-SIB.
  • Spark asset fire sales.
  • Transmit financial risk across the US financial system.
For the purpose of the proposed rule, covered entities include any:
Under the proposed rule, G-SIBs must ensure that:
  • QFCs to which a covered entity is a party must provide that any default rights and restrictions on the transfer of the QFC are limited and treated in a similar manner as under Title II of the Dodd-Frank Act which established the Orderly Liquidation Authority (OLA), and Federal Deposit Insurance Act (FDIA) (see Practice Note, Summary of the Dodd-Frank Act: Resolution of Failing Financial Institutions). This requirement is designed to address a threat to financial stability posed by the failure and resolution of an internationally active G-SIB by ensuring equal treatment for all covered QFCs, including those:
    • that are governed by foreign law;
    • that are entered into with a foreign party; or
    • for which collateral is held outside the US.
  • Covered entities would generally be prohibited from entering into QFCs that:
    • allow the exercise of cross-default rights (related either directly or indirectly to the entry into resolution of an affiliate of the direct party); and
    • provide for a restriction on the transfer of credit enhancements supporting the QFC from the covered entity's affiliate to a transferee upon the entry into resolution of the affiliate.
The proposed rule would also amend certain definitions in the FRB's capital and liquidity rules to ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party are not affected by the proposed restrictions on QFCs. Specifically, the proposal would amend the definition of the terms:
  • "qualifying master netting agreement" in the FRB's regulatory capital and liquidity rules;
  • "collateral agreement" in the FRB's regulatory capital rules;
  • "eligible margin loan" in the FRB's regulatory capital rules; and
  • "repo-style transaction" in the FRB's regulatory capital rules.
The QFC proposal seeks to maintain consistency between restrictions on financial contracts under Title II of the Dodd-Frank Act that support the orderly resolution of financial firms. The proposal would help ensure that all QFC counterparties would be treated in the same way in the orderly resolution of a particular G-SIB.
The proposal is part of the overall FRB effort to address one of the many ways in which the failure of a systemically important financial company can damage the US financial system. Staying termination rights in derivatives and other financial contracts is designed to limit fallout from the interconnectivity among these institutions created by these agreements. The proposal focuses on improving the orderly resolution of G-SIBs by limiting disruptions to a failed G-SIB through its financial contracts with its counterparties.
The proposed rule was developed by the FRB with input from various US financial regulators. The FRB has consulted with foreign financial regulatory authorities to facilitate the orderly cross-border resolution of a failed G-SIB on an international basis.
The FRB has also coordinated with the Office of the Comptroller of the Currency (OCC), and the OCC is expected to issue its own proposed rulemaking to subject covered banks, including the national bank subsidiaries of G-SIBs, to requirements substantively identical to those included in this proposed FRB QFC rule.
The proposal is open for public comment until August 5, 2016.
Update: On August 19, 2016, the OCC issued a corollary proposed rule that would subject covered banks to stay-and-transfer provisions substantively identical to those in the FRB QFC proposal. Public comment on the OCC's proposed rule must be received by October 18, 2016. Comments can be submitted by mail, email, or through the Federal eRulemaking Portal.