Federal regulators moved swiftly today and finalized new “liquidity coverage ratio” rules while also starting the process of tackling one of the biggest and most catastrophic risks facing the world economy: big bank derivatives exposure.

The new leverage ratio rule

The Leverage Ratio rule requires nearly 35 banks to maintain a large percentage of highly liquid assets. As a result, the large banks will likely be required to alter their investment portfolio and raise by $100 billion highly liquid assets. As previously reported in ValueWalk, the goal of the rule is better protection during a market crash. If markets were to “freeze up” again, particularly in lightly traded over the counter debt instruments and derivatives products, it could cause major problems for the large banks and require another government bailout.  During the 2008 market crash, 12 of the 13 large banks faced an immediate need for cash as they were set to fail, forcing the government to quickly act — some say in haste — to stem what could have destroyed the world economy.

derivatives

While the rule is designed to manage risk during a market crisis, analysts warn of a double edge. During good times the added liquidity requirements may discourage banks from lending or investing, analysts in a Wall Street Journal report warned.

For financial wonks, a Fed statement defined the rule:

The final rule modifies the methodology for including off-balance sheet items, including credit derivatives, repo-style transactions, and lines of credit, in the denominator of the supplementary leverage ratio. The final rule also requires institutions to calculate total leverage exposure using daily averages for on-balance sheet items and the average of three month-end calculations for off-balance sheet items.

Janet Yellen: The balance between risk and reward

Fed Chairwoman Janet Yellen, however, has been querying staff economists on the issue, who note the balance between risk and reward. “To some extent (it could) make credit a bit more costly, but weighed against that is that these regulations will cause financial crises to be less likely and less frequent and less severe,” Bill Nelson, a Fed economist, was quoted as telling Yellen.

During her brief start, Yellen has been aggressive at addressing difficult systemic risk issues commonly discussed in whispers among financial insiders, but sometimes reported in public, mostly through ValueWalk.  Much of her work involves confronting the large banks, who have powerful if little reported influence inside the U.S. Federal Reserve.

Yellen’s toughest task could have been outlined in a press release today when bank regulatory agencies opened the floor to public comment on Swap margin requirements. This refers to the amount of capital banks are required to set aside for derivatives contracts that underlie the world financial system to the tune of nearly $700 trillion. Creating a margin requirement on derivatives exposure that is nearly seven times the size of the world economy, and significantly higher than the banks have in available capital, will not be an easy task.

The balancing act is coming up with margin requirements that both adequately protect the world economy from derivatives implosion while not restricting the banks from making loans to prime the economy.

Banks might be required to publicly disclose derivatives exposure

One interesting proposal to consider might be to require the banks to publicly disclose their derivatives exposure, a suggestion made by US hedge fund magnet and reported in ValueWalk. With this information public, the free market could force the banks hand to a degree.

Speculation as to the big bank’s market exposure has tended to favor a short volatility position in the interest rate markets, leaving the banks open to damage if volatility and price direction in interest rates were to suddenly rise.

While margin requirements are a key to helping manage the problem, the real solution will likely come from a combination of efforts: margin requirements, a living will that clearly outlines how the banks will dismantle their derivatives exposure under worst case situational analysis, and bringing transparency into the market place regarding the size of derivatives exposure and importantly the specific markets and risks that are being managed.

Can Janet Yellen pull it off without damaging the viability of the banks? That remains to be seen. But the tightropes she is walking with regards to derivatives, unwinding quantitative easing and keeping the economy afloat are perhaps the most daunting tasks the Federal Reserve has addressed since Alan Greenspan was chairman. Consider that Greenspan and Ben Bernanke who followed him as Fed chair had the easy job of turning on the money faucet.  It is Yellen who will be required to tell the markets the party — and free drinks — are about to come to a conclusion. She is required to accomplish his while confronting a big bank derivatives challenge in her spare time.

Good luck, Janet.