From the Regulators

“Final rule” aims to prevent mass unravelling of financial contracts should one major institution fail

By James Langton |

U.S. banking regulators adopted a "final rule" today that aims to guard against systemic risk posed by the failure of a financial institution that is highly interconnected with other firms.

The U.S. Federal Reserve Board's rule is designed to enhance financial stability by requiring U.S. global systemically important banking institutions (GSIBs), and the U.S. operations of foreign GSIBs, to prevent the immediate cancellation of certain financial contracts — such as derivatives, repos, and securities lending arrangements — if the firm enters bankruptcy. The mass termination of these sorts of financial contracts could spark asset "fire sales" and spread distress across the financial services system.

"The final rule should help avoid the threat of a disorderly and mass unravelling of [financial contracts], as occurred in the case of Lehman Brothers, which intensified and prolonged the financial crisis [of 2008-09]," said U.S. Federal Reserve Board governor Jerome Powell. "The final rule is tailored to apply only to the GSIBs — the banking organizations whose disorderly failure or severe distress would likely pose the greatest risk to U.S. financial stability and the broader economy."

The final rule requires these contracts to clarify that U.S. resolution laws provide a temporary stay to prevent the mass termination of these contracts. It also prohibits the exercise of default rights that could spread the bankruptcy from one GSIB entity to affiliates that are otherwise solvent. The rule's requirements will be phased in starting on Jan. 1, 2019.

"The financial crisis showed that, when a large financial institution gets into trouble, its failure can destabilize other firms and the broader financial system," said Fed chair Janet Yellen. "One reason this might happen is that the very largest banks are interconnected through substantial volumes of financial contracts. [The new rule] will help manage the risk to the financial system when a GSIB fails, and will thus strengthen the resiliency of the financial system as a whole."