Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Paperwork Risk Management

Very serious people love to complain about the redundancy and chaos of our overlapping financial regulators, but sometimes being a mess has its advantages.

One of those is that we sometimes get a diversity of views that a more centralized, homogenized regulatory structure would drown out.

Witness, if you will, the regulators divide over this move by Bank of America to move its derivatives from Merrill into the FDIC backed depository unit of Bank of America.

From Bloomberg:

Bank of America Corp. , hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people.

The Moody’s downgrade spurred some of Merrill’s partners to ask that contracts be moved to the retail unit, which has a higher credit rating, according to people familiar with the transactions.

Transferring derivatives also can help the parent company minimize the collateral it must post on contracts and the potential costs to terminate trades after Moody’s decision, said a person familiar with the matter.

This should be considered outrageous behavior. It's not just that Bank of America is very obviously exploiting government backing for profit, it's that Bank of America's counterparties are also exploiting the government for profit.

Think about it this way: There's no real risk at all that Bank of America will let Merrill default on its derivatives contracts, but because the unit has been downgraded, counterparties are required on technical risk management and regulatory grounds to demand more collateral. This can be avoided by simply shuffling paper, which does nothing to reduce risk.

In other words, this is not about reducing risk at all, it's about regulatory arbitrage and paperwork risk management.

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