The Latest Way American Banks Are Avoiding Regulation

American banks are quietly changing the terms of their European swaps contracts to avoid American regulations. Is this the beginning of a brave new era of regulatory arbitrage?

May 17, 2014 at 11:00AM

The largest players in the derivatives markets -- JP Morgan (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS) -- have started to change the terms of their European swaps contracts to avoid American rules that increase transparency and increases price competition.

Essentially, these banks are quietly altering the contracts so that it is no longer the American parent company being the key player, causing American banks to be able to easily circumvent American regulations.

What is a swap again? 
In their most basic form, a swap means that two parties have differing views about the future cash flows a financial instrument will generate. If I think a company's bond is a sure thing, I might agree to pay a floating rate to you that's based on the value of the bond. If you're not so sure or you want insurance against a default, you may agree to pay me a fixed rate in exchange. If the company goes bust then you're covered, but if all goes well then I get a steady flow of income. 

If it sounds like an insurance policy, that's because it essentially is one.

These swaps aren't a bad thing in and of themselves. The trouble comes if something goes sour and one party can't pay. It's also hard to get an understanding of the level of exposures that each party faces. As you may have noticed from the chart above, banks aren't exactly entering into a handful of contracts each year. It's an enormous market with a network of exposures that no one, including regulators, really seems to grasp. 

This is the reason for all of the new rules. 

Why swaps?
Like most things in regulatory compliance, it all seems rather arcane at first. For example, this loophole applies uniquely to swaps, which are traded privately between parties (rather than on exchanges, like stock options.) The idea was to draw swaps out into public view to provide more insight into what banks are actually doing. 

Isn't getting risk out of the U.S. a good thing?
Some people might argue that it isn't such a bad thing if American parent companies no longer guarantee the swaps contracts made by their European arms. The reasoning is that if the parent is no longer responsible, it can't hurt the U.S. financial system. 

Let's be realistic. Even in the event that the American parent company leaves its affiliate hung out to dry (seems unlikely), the systemic implications of these problems aren't geographically limited. Say there's a financial shock fueled in part by swaps contracts in the UK. Even if the U.S. government doesn't have to bail out American banks, we're not going to be immune to the fallout. 

Transferring risk doesn't eliminate it. It just moves it. 

Regulatory arbitrage
The other problem here lies with oversight. While we're just talking about swaps for now, the strategy of skirting the rules doesn't occur in a vacuum. 

Banks are deliberately taking advantage of differences between American and European regulations. Between regulatory capital trades, regulatory arbitrage by European banks operating in the U.S., and now this, this is just part of a larger trend that increases systemic risk and reduces visibility into the banks themselves. 

As I've said before, partial rule coverage is like partial vaccination of a population. It just doesn't work. Add to that the fact that regulators are barely able to manage the information they have now, and you have a recipe for trouble. 

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Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Goldman Sachs. The Motley Fool owns shares of Bank of America, Citigroup, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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