Bank rule to limit damage in financial crisis
The Federal Reserve proposed a rule Tuesday aimed preventing the type of widespread asset sales that rippled through the banking system and worsened the 2008 financial crisis when Lehman Bros. declared bankruptcy.
Under the rule, investment firms such as hedge funds would not be able to immediately cancel contracts for derivatives or certain loans issued by large banks that begin bankruptcy proceedings, as long as the banks continue to pay interest or fulfill other obligations on the assets.
Instead, the firms would have to wait at least 48 hours before taking such action. That would provide time for a the teetering bank to be wound down so that its healthy units and their performing assets are preserved in separate companies while failing divisions are dissolved.
During the financial crisis, the bankruptcy of Lehman prompted its counterparties to exercise their rights to default on contracts such as swaps and derivatives and to sell related collateral, and that in turn deepened Lehman’s downward spiral and sharply reduced the prices of the assets sold.
“These terminations… can destabilize the financial system and potentially spark a financial crisis,” the Fed said in a staff memo to its board of governors. The contract cancellations can trigger “a chain reaction that can ripple through the system” and “firesales of large volumes of financial assets.”
“The crisis underscored that when a large financial institution gets into trouble, its failure can destabilize other firms,” Fed chair Janet Yellen said in a statement.
The proposed rule, which was released Tuesday for public comment, would require the nation’s largest banks, such as JPMorgan Chase and Citigroup, to write new contracts that specify the constraints. Existing agreements also would be affected if a counterparty enters into new contracts with the banks.
The banks themselves already comply with the restriction for dealings among themselves based on global financial reform. The rule would extend the requirements to contracts with other firms.
The Fed notes that bank counterparties likely would seek more favorable contract terms to offset the proposed restraints.
Separately, the panel proposed another rule requiring the largest banks to hold enough cash for a year to provide a cushion for riskier assets, such as derivatives. The Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency released that measure late last month.
