As banks structure deals to circumvent the Federal Reserve System’s new liquidity coverage ratio proposal (‘LCR’), regulators scramble to protect the financial industry from another fiscal meltdown.
The LCR compels banks to maintain a liquidity amount equal to its projected cash flows minus the projected cash inflows. To meet this requirement, banks have been forced to cut their borrowing and are funding their operations using equity raised by the sale of shares. Consequently, the profit-making ability of the banks has been limited.
To counter these difficulties, banks structure deals that transfer risk to affiliated entities, thereby projecting an artificial capacity to absorb risk and circumvent the liquidity requirement of the LCR. A credit-default swap (‘CDS’) is the typical trade structure employed by banks to meet these ends. The bank, through outside investors, buys a CDS with loans from its special purpose vehicle. If the deal is successful, the investors receive a substantial annual fee for taking the risk. However, if it fails, the investment is lost. The insurance giant, American International Group (AIG) came close to collapse in 2008 as a result of employing such a deal trade. Other major banks such as Citigroup, UBS and Credit Suisse have entered similar transactions.
Reacting to the deals entered into by Citigroup, Credit Suisse, UBS, and other banks, the Federal Reserve has said that it will strongly scrutinize deals that have a bearing on the bank’s balance sheet. Its rigid attitude may be attributed to its endeavor to plug the risk-transfer loophole and prevent a repetition of the 2008 financial crisis. In 2008, the banks diverted risk to unregulated areas of the market, and when these transactions failed, the banks were forced to incur huge losses that accrued from implied obligations from the transferred risks. The Federal Reserve has indicated it will permit risk-averting transactions if the entity to which the risk is transferred is not affiliated with the transferring bank and can independently absorb the risk. Furthermore, if an entity bears a limited percentage of the risk, the bank shall be expected to bear the remaining percentage.
The outstanding question: Will these measures strike an appropriate balance between banks and regulators?