FT Alphaville " Fed seeks to break up long-standing US bank lovefest Earlier this year the Fed proposed new rules that would limit banks" exposure to each other even more than the Dodd-Frank reforms, coming into force next year, already demand. The banks went away to think about it, and it's safe to say they have some concerns. Goldman Sachs, in fact, has sent the Fed 20 pages-worth of its concerns just ahead of a meeting in New York today with Daniel Tarullo, the Federal Reserve governor, and assorted big bank executives. In short, Goldman summarises, "parts of the Proposed Rules appear likely to damage, rather than strengthen, the systemic safety of the US financial sector and ultimately the US economy." Oh, and it's going to cost the US up to 300,000 jobs according to their calculations and cut economic growth by up to 0.4 per cent. Morgan Stanley also has complaints, in particular to do with its Japanese joint venture with Mitsubishi UFJ Financial Group. The new rules would require it to add the JV's exposures to Morgan Stanley's own, apparently with grave consequences for the whole Japanese bond market. The FT quotes the bank arguing: The illogical attribution of [the joint venture's] exposures to Morgan Stanley would, in practice, significantly constrain Morgan Stanley's ability to enter into new credit transactions not only with the Japanese government but also with Japanese and non-Japanese financial institutions and other Japanese counterparties and would very likely require the reduction of existing credit transactions with such counterparties. The broad idea behind the regulator's move is sensible, in that they are trying to avoid a "domino" effect if one bank goes under. The Dodd-Frank rules restrict the amount of exposure banks can have to a single counterparty to 25 per cent of their regulatory capital. But the Fed wants to also introduce a 10 per cent limit on the exposure that financial groups with more than $500bn in assets can have to each other. But how do you calculate counterparty exposure? Goldman has objections to the Fed's proposed methodology (our emphasis): The technical flaws in CEM [Current Exposure Methodology] and the substitution approach together substantially overstate counterparty credit exposures when compared to more risk-sensitive methodologies, such as the Internal Model Methodology that has been approved by the FRB in the context of capital requirements. The degree of overstatement depends on the nature of the portfolio and is particularly acute for interbank portfolios characterized by a large number of transactions and low net risk. A preliminary examination of 50 such portfolios indicates that the overstatement is in the range of four to eighteen times the actual counterparty exposures as measured by IMM. Part of the issue here concerns the benefits of netting. This chart, from the Office of the Comptroller of the Currency, just looks at US commercial banks, but is nevertheless illustrative of the significant amounts of gross credit exposure that banks are eliminating through bilateral netting. Note that netting benefit here is defined as "$ amount of netting benefits/gross positive fair value". A major concern for the banks is the effect of all this on the derivatives market. Just five banks held 96 per cent of the US banking industry's notional holdings in derivatives in December, according to the OCC. Bloomberg has a quote from Brian Leach, Citigroup's chief risk officer, in another letter to the Fed (emphasis ours): [The proposed limits] greatly overstate credit exposures, particularly with respect to counterparty exposure arising from derivatives. The overstatement of the credit exposure will require financial institutions to substantially reduce lending to customers, reduce market-making activities in derivative instruments on behalf of customers, and either purchase less credit protection, or purchase credit protection from smaller, less well-capitalized institutions or from "shadow banking" firms. Did Citigroup's CRO just threaten to push more risk into the shadow banking sector? Well, that's a tactic we haven't seen before. Looks like it's going to be a lively meeting with Tarullo and the banks execs later today. Related links: Goldman Says Rule Curbing Counterparty Links Risks Jobs - Bloomberg Banks urge Fed retreat on credit exposure - FT This entry was posted by Masa Serdarevic on Wednesday, May 2nd, 2012 at 12:48 and is filed under Capital markets. Tagged with Dodd-Frank, US banks.