Led by JP Morgan, banks take on Fed's credit limit plan

Led by JP Morgan, banks are lobbying against the Fed's plan to impose a credit limit that would restrict their exposure to any single bank, company or sovereign to 10% of their total counter-party exposure.

The reason for limiting this exposure is to reduce contagion in the financial system during a financial crisis.

Regular readers know that mechanical credit limits like this are a poor substitute for ultra transparency.

By requiring the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, each counter-party can assess the risk of the other counter-party.  As a result, they adjust both the price and amount of their exposure to the counter-party to reflect this risk.

Each bank knows to do this because it knows that it is responsible for all gains and losses on its exposures.  As a result, each bank will manage it exposures so that any losses that arise from these exposures do not exceed its capacity to absorb the losses.

Since investors also have the information disclosed under ultra transparency, they will provide the market discipline necessary to insure that banks manage their exposures within their capacity to absorb any losses.  Investors have the incentive to do this because it is their investment that will be wiped out.

According to a Bloomberg article,

JPMorgan Chase & Co. (JPM) said a Federal Reserve proposal to cut risk by capping a bank’s dealings with any one lender, corporation or foreign government fails to strike the “correct balance” and may harm financial markets. 

The plan “could destabilize markets,” Barry Zubrow, executive vice president of corporate and regulatory affairs for JPMorgan, said yesterday in a comment letter to the central bank. 

The Fed is reaching “well beyond” the Dodd-Frank reform legislation with “disruptive” standards that duplicate or conflict with other rules and directives, he wrote.... 

Fed Governor Daniel Tarullo will meet tomorrow with chief executive officers of the biggest banks including JPMorgan’s Jamie Dimon to discuss the limits... 

The proposal to limit credit exposure is designed to contain the damage if a large company, foreign government or bank should fail and threaten to take down other institutions with it. 

Under the rule, a firm deemed systemically important couldn’t have more than 10 percent of its counterparty risk tied to one entity. The 2010 Dodd-Frank Act proposed a 25 percent cap while giving the Fed authority to tighten the standard to ensure stability in financial markets....

Bankers including Zubrow say the Fed’s model for counterparty exposure inflates rather than decreases their risk.  The rule also would restrict the ability to execute certain risk-management or hedging transactions, he said. 

Zubrow foresees “additional pressure to unwind largely offsetting trades in a potentially disruptive manner -- trades that an accurate measurement methodology would not show as producing meaningful risk,” he wrote. “These methodologies produce very large misstatements -- and, in most cases, overstatements -- of the true counterparty exposure.”...

One of the problems with mechanical credit limits is that they are subject to bank lobbying.

In this case, the goal of the lobbying is to redefine the credit limits in such a way that they are not a binding constraint on the banks' day to day operation.

The Fed, in proposing the rule, said the financial crisis revealed a failure of regulators to spot concentrations in credit risk and the interconnectedness of financial firms “that contributed to a rapid escalation of the crisis.”

Bottom line: by adopting ultra transparency, the Fed could enlist the market to help deal with the issues of spotting concentrations in credit risk and reducing the interconnectedness of financial firms.