Fed Demands Wall Street Protections Against Lehman-Like Runs

(Bloomberg) -- The Federal Reserve has approved a rule that will keep derivatives contracts from being canceled immediately when financial firms fail -- a move considered crucial to keeping a future calamity at one Wall Street bank from spreading.

The Fed board voted at a meeting Friday to require that financial contracts include a temporary halt on the ability of firms to terminate deals when trading partners collapse. The pause is meant to give regulators or courts time to stabilize the failing firm and eliminate the need to cancel the contracts at all. 

“The very largest banks are interconnected through substantial volumes of financial contracts,” Fed Chair Janet Yellen said in a statement. Unless those contracts can be kept from unraveling, they can spark “asset fire sales that can consume many firms.”

The goal is to head off the kind of chaos that followed the 2008 bankruptcy of Lehman Brothers Holdings Inc., which accelerated the financial crisis. Besides derivatives, the regulation also affects repurchase agreements and securities lending, according to the regulator.

Global Strategy

The Fed’s action is meant to formalize a strategy already pursued by the industry. Major global banks agreed in 2014 to voluntarily make such changes to their contracts, inserting stays into the vast majority of these transactions that are the lifeblood of the global financial system. 

But critics among hedge funds and insurance companies -- which are often on the other side of the contracts -- complained that the bankers were taking protections away from customers without giving them any say in the matter. Fed Governor Jerome Powell said the agency tried to give such firms a break by allowing the industry a longer period to change the contracts that affect them and by reducing the overall scope of pacts that need modifications.

U.S. regulators have worked to align domestic rules with an international agreement to mandate the pauses. After the crisis, it became a global priority for banking regulators to prevent derivatives runs so that the biggest lenders could be taken down in a failure without risking the financial system.

The Fed’s rule says that contracts with the largest U.S. banks and the U.S. arms of major foreign banks have to include the provisions that halt early terminations, and the agency predicted its rule will mean only a “modest” additional cost to the industry. Each termination delay can be as long as 48 hours but is generally one business day.

The requirement will take effect in January 2019 for transactions between the largest banks. Contracts between big banks and other financial firms will have to include stays starting in July 2019. The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency are expected to follow with similar rules, the Fed said.

--With assistance from Craig Torres

To contact the reporter on this story: Jesse Hamilton in Washington at jhamilton33@bloomberg.net.

To contact the editors responsible for this story: Jesse Westbrook at jwestbrook1@bloomberg.net, Gregory Mott