TEXT-Fitch: counterparty limits to challenge concentration, liquidity

May 4 - The Federal Reserve's "Enhanced Prudential Standards and Early
Remediation Requirements for Covered Companies" proposal attempts to address
interconnectedness between U.S. financial firms and their impact on financial
stability, specifically highlighting single-counterparty exposure limits. Fitch
Ratings believes the proposal is conceptually a good one, but questions
surrounding implementation make it challenging to gauge the potential impact.

We believe that if the rule is implemented over time and risk can be diversified
to multiple other counterparties, it could achieve its intent to reduce
interconnectedness. However, given the current concentration of activity among
the largest systemically important financial institutions (SIFIs), particularly
in derivatives and other market-making activities, it will be difficult to
realize.

In addition, at some point, we expect that central clearing parties, such as
exchanges and clearinghouses, may be designated SIFIs, but are unlikely to
approach the $500 billion threshold. We have concerns that the move to central
clearing, while theoretically a good one, will shift systemic risk to these
parties and the less restrictive limits will apply.

The proposed rule suggests that SIFIs with more than $500 billion in
consolidated assets should have their counterparty exposure to other large SIFIs
limited to a maximum of 10% of counterparty capital stock and surplus. Under
Dodd-Frank, the cap is 25%, but the Federal Reserve has the authority to reduce
the counterparty exposure limit to mitigate risks to financial stability. The
25% limit applies to other single-counterparty exposures.

In its proposal, the Fed notes that counterparty concentrations, particularly
between the largest financial institutions, contributed to the
interconnectedness of the financial system and heightened risk to the U.S. and
global financial system. The more restrictive counterparty limit between large
SIFIs (over $500 billion in assets) is designed to prevent an unraveling of the
financial system in the future should one of the large banks collapse.

We believe while the proposed rule would add regulatory burden to the banks, it
would also and perhaps more importantly call for a challenging deciphering of
how a 10% limit would impact volumes, business profit, and what portion would be
related to client facilitation. In addition, the rule calls for compliance one
year after standards are finalized that could be disruptive to market liquidity
as it leaves little times for the firms and the system to adjust to these
changes.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market
commentary page. The original article, which may include hyperlinks to companies
and current ratings, can be accessed at www.fitchratings.com. All opinions
expressed are those of Fitch Ratings.