Banking and Finance Law Daily Fed finalizes rule restricting termination of qualified financial contracts
Tuesday, September 5, 2017

Fed finalizes rule restricting termination of qualified financial contracts

By Stephanie K. Mann, J.D.

The Federal Reserve Board has adopted a final rule to enhance financial stability by requiring U.S. global systemically important banking institutions (GSIBs) and the U.S. operations of foreign GSIBs to amend qualified financial contracts (QFCs) to prevent their immediate cancellation or termination if the firm enters bankruptcy or a resolution process. Compliance for this final rule will begin on Jan. 1, 2019.

Final rule. According to the final rule, QFCs include derivatives, securities lending, and short-term funding transactions such as repurchase agreements. Given the large volume of QFCs to which GSIBs are a party, the Fed believes that the mass termination of QFCs in the event of financial distress or failure of a GSIB may lead to the failure of the firm, spark asset fire sales, and transmit financial distress across the U.S. financial system.

In order to combat this potential risk, the final rule contains two key requirements. First, QFCs of GSIBs, including those with foreign counterparties, are required to clarify that U.S. resolution laws providing for a temporary stay to prevent mass terminations apply to the contracts. Second, QFCs of GSIBs are prohibited from allowing the exercise of default rights that could spread the bankruptcy of one GSIB entity to its solvent affiliates.

GSIBs may comply with the final rule by using the International Swaps and Derivatives Association 2015 Universal Resolution Stay Protocol or a similar resolution stay protocol described in the final regulation to amend their QFCs.

Transition period. The Fed has tailored the transition period based on the type of counterparty after receiving numerous concerns through comment letters submitted to the agency. The final rule requires GSIBs to conform their QFCs with other GSIBs within one year and within 18 months for QFCs with most other financial counterparties. Additionally, GSIBs would have two years to conform QFCs with community banks and all other counterparties. The final rule also excludes QFCs that do not contain default rights or restrictions that could undermine the orderly resolution of a GSIB.

Opening remarks. At the Fed meeting to discuss the final rule, Fed Chair Janet Yellen said that the final rule will reduce the potential for a systemic failure of a GSIB, thereby helping to prevent destabilization of other firms and strengthen the resiliency of the financial system as a whole.

Fed Governor Jerome H. Powell added that the rule will help "ensure that appropriate temporary stays would apply to a broad range of the foreign and domestic QFCs of a failed GSIB, regardless of whether the resolution is conducted under the Federal Deposit Insurance Act, the Dodd-Frank Act, or the Bankruptcy Code. Accordingly, the final rule should help avoid the threat of a disorderly and mass unraveling of QFCs, as occurred in the case of Lehman Brothers, which intensified and prolonged the financial crisis."

statement from Fed Governor Lael Brainard emphasized that the rule will bolster "financial stability by requiring that the QFCs of GSIBs do not trigger a disorderly and rapid failure that would complicate the firm's resolution and spread financial instability through the rest of the financial system."

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