Thursday, October 27, 2011

Senator and Congressman Query FSOC on Transfer of Complex Derivatives from Securities Arm to Retail Bank Within Large Financial Institution

In a letter to Treasury Secretary Tim Geithner and other FSOC Members such as the SEC and CFTC, Senator Sherrod Brown (D-OH) and Rep. Brad Miller (D-NC) expressed concern that a large financial institution transferred risky derivatives from its securities trading subsidiary to its FDIC-insured retail bank subsidiary. The derivatives are apparently complex, opaque, and not remotely standardized, noted the lawmakers. The Treasury Secretary is the Chair of the Financial Stability Oversight Council. The lawmakers posed a series of questions about the transaction and asked FSOC and the Secretary to promptly respond.

Senator Brown and Rep. Miller ask if the transfer of the derivatives was reviewed under Section 23A of the Federal Reserve Act, and if not, why not. Section 23A limits transactions between non-bank and bank affiliates to protect the safety and soundness of banks and to avoid effectively subsidizing high-risk transactions with deposit insurance. Because of the favored treatment of derivative contracts in receivership, reasoned the Senator and Rep., it appears highly likely that losses on derivatives would result in losses to insured deposits ultimately borne by taxpayers.

The transaction would avoid the reporting and review threshold of Section 23A, they noted, only if the transfer was of high-quality assets constituting less than ten percent of the retail bank’s capital stock and retained earnings. The reported demand by counterparties that the securities subsidiary transfer the derivatives to the retail bank to avoid a possible requirement to post additional collateral suggests that the derivatives pose substantial risk. The lawmakers ask FSOC if the transfer was treated as an asset purchase of the derivates by the retail bank from the securities trading subsidiary. If so, they want to know if the purchase price in what was obviously not an arm’s-length transaction was used to determine the applicability of Section 23A.

If regulators did review the transfer, either for purposes of approval under section 23A or to determine if such a review was required, the Senator and Congressman want to know if the regulators determined the risk posed by the derivatives. They also want to know if the securities subsidiary and the financial institution made their proprietary models available to regulators to assess that risk. Also, they query if any of the derivatives are credit default swaps on European sovereign debt and, if so, what effect would default on European sovereign debt have on potential liability under the swaps.

Moreover, if the financial institution completed the transaction without reporting under Section 23A, what measures are available to regulators who disagree with the contention that reporting and review under Section 23A was not required. Thinking of possible remedial action, the legislators ask if regulators can require rescission of the transfer and if the transfer of the derivatives to the retail bank would put insured deposits at risk or would the transfer of the derivatives back to the securities trading arm create a systemic risk to the financial system.
Finally, if the transfer was not reported and reviewed under Section 23A based on the financial institution’s own assessment of the transfer, Sen. Brown and Rep. Miller want to know if regulators would allow reporting and review under Section 23A to be an honor system in the future.

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