BofA’s derivatives move – facts and fallacies October 21, 2011 at 6:25 am

Goodness me there are some fishy things being written about BofA moving their derivatives to the retail bank (which of course has FDIC insured deposits). Some of the things that are not true include ‘If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral’ and ‘The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties.’ (These actually consecutive sentences too – clearly Reuters does not bother to fact check blogs.)

What is true is that a retail bank often has rather better liquidity than a broker/dealer. This alone makes it safer, and hence (assuming that liquidity does not get spread around the rest of the group – something that should not happen too much) the retail bank is more attractive as a derivatives counterparty. Note though that these days everyone uses the same interdealer CSA (zero threshold, daily margin, cash only), so there is no collateral advantage to being in the retail bank; moreover being in a retail bank doesn’t suddenly make derivatives super senior; they are just good only fashioned pari passu with senior debt, the way they always were – and not FDIC-protected.

5 Responses to “BofA’s derivatives move – facts and fallacies”

  1. Seems to me though that if you were planning to strip assets from the retail bank and use them against a failing derivatives operation – or if you were planning on exploiting deposit insurance to effectively get a government subsidy for your risk-taking, then something like this would be a useful first step. Also, although unsecured derivatives exposures are pari passu this is a bit misleading to the nonspecialist reader, as the point here is surely that the derivatives counterparties have an unusually perfect security over their collateral and banks aren’t usually able to proliferate senior charges over their assets in the way that derivatives CSAs work.

    Kind of like setting up an off balance sheet vehicle that’s neither consolidated nor separately listed – not evil or illegal in and of itself, but something that facilitates the doing of all sorts of things that you shouldn’t. I agree with you that the transaction itself has a lot of rubbish written about it but I can totally see why the FDIC was not at all keen on it.

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  3. D2 – I don’t disagree with any of that. However, assets with a pledge over them don’t count for Basel III liquidity purposes, so that (at least if ever implemented in the US) would stop using too many deposits to provide cash collateral for derivatives.

  4. One might also add that, unlike some assertions, particularly by Bill Black, there is absolutely no “stripping” of the banks assets – any transfer between ML and BofA would have to be at market.

    To dsquared’s point, this seems very parachoial on the part of the FDIC. Arguably, having the derivatives book in the bank (which has greater liquidity than the ML sub) is stabilizing for the firm. The FDIC is narrowly focused on protecting the deposit insurance fund – it should remember that it now too has systemic risk responsibilities under Dodd-Frank. I presume most can agree that were BAC to fail the knock-on consequences (to the financial system and the economy) would likely be greater than the direct losses to the fund.

  5. […] There’s a counter to a couple of points made by Felix on Deus Ex Macchiato. […]