US large exposures rule could stop banks trading with RBS

Federal Reserve proposals limiting counterparty risk could put RBS and the UK government in one pot – potentially forcing US banks to cut exposure to both.

US banks could stop trading with Royal Bank of Scotland (RBS) – or reduce their role as market-makers for UK government bonds – as a result of Federal Reserve Board proposals that limit large single-counterparty exposures.

As drafted, the rules could lump together exposures to RBS and those to the UK, causing US banks to breach their limit. RBS warned of the possible consequences of the rules in a comment letter on April 30, and two US banks that spoke to Risk confirm the rules could affect their ability to trade with RBS and to hold gilts.

“Our lawyers think it’s a credible argument that you’d have to consider them the same,” says an expert at one industry association.

A source at one US bank says it has already worked out its aggregate exposure to the UK government under the terms of the rules, including RBS. It found that it breached the Federal Reserve limit – meaning the bank would need to cut its exposure to RBS, reduce its inventory of gilts, or a combination of both, the source says.

The proposed rule, published by the Federal Reserve on January 5, and originating from Section 165(e) of the Dodd-Frank Act, would prevent a US bank from having an exposure to a single counterparty that exceeds 25% of the bank’s capital. Exposures between so-called major covered companies – banks and other large financial institutions with more than $500 billion of consolidated assets – are limited to 10%.

Exposures guaranteed by the US government and agencies – plus Fannie Mae and Freddie Mac – are exempt from the limits, but US state and local government exposures are not; neither are exposures to foreign sovereigns, which include sovereign agencies and “instrumentalities”. The UK government’s 82% shareholding in RBS could therefore mean that US banks’ exposures to both parties would be combined and could not exceed 25%.

That may sound generous. The problem, banks say, is that the proposals would calculate derivatives counterparty risk using the counterparty exposure method (CEM) – a relatively crude measure borrowed from the Basel II bank capital rules, which severely limits netting benefits and therefore overstates the exposure. In addition, while a bank would be allowed to reduce gross counterparty exposure by subtracting collateral – subject to prescribed haircuts – the bank would then have to recognise an exposure to the issuer of the collateral. So if RBS had posted gilts or sterling-denominated cash as collateral, it would not reduce the US bank’s aggregate exposure to the UK.

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