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.