Similar to any other legislation, it is not surprising to find loopholes in the Dodd-Frank Act. But when loopholes allow “collateral transformation,” potential consequences are questionable.
As has previously been reported, the Dodd-Frank reforms require derivative deals to be executed on a clearinghouse. This means that traders will need to post collateral while regulators will have a central place to spot risks in the market.
However, it seems that some of the country’s largest banks have a plan to help clients work around the measure. In short, the scheme allows traders to repackage high risk securities into the high-grade bonds that clearinghouses require traders to post as collateral.
This task can be accomplished by “temporarily” swapping low-grade (high risk) securities for high-grade (low risk) bonds such as Treasuries. This is a win-win for traders and the banks because traders have the quality collateral while the banks collect fees and interest for lending.
However, if traders are wrong the banks will be left holding risky bonds instead of high-grade securities. Moreover, if the banks borrow the high-grade bonds, the original lender could set off a ripple effect through the market by calling back the collateral.
And so, a downward spiral could follow that the Dodd-Frank reforms are supposed to prevent. Of course, banks contend that swapping collateral does not shield risk because the banks are regulated and still have to adhere to capital requirements. This, in turn, means that there are lending limitations already built into that can mitigate their losses in the event that a trader goes down.
The overarching argument for bankers is that so-called “collateral transformation” is not that risky because it is a short-term, established type of lending that must meet tight capital and liquidity rules. Further, these rules are becoming even tighter by way of other Dodd Frank reforms as well as the Basel III accord that is built on much stricter capital requirements – so strict in fact that one major bank’s CEO has labeled the rules as “un-American.”
In the final analysis, regulatory measures historically have loopholes built into them. But the question remains whether taxpayers will be left hanging in the event of another financial crisis.
