Clearing the pitch

Bank overseers take calculated risk on derivatives

Trading derivatives entails taking a calculated risk and hoping for the best. So does overseeing the banks that do it. That helps make sense of the Basel Committee's latest consultation on how these weapons of financial mass destruction should be regulated.

The global financial crisis was partly caused by traders and clients using derivatives to take leveraged bets without a safety net. Since then the Group of Twenty nations has mandated that instruments like swaps should be cleared through central clearing houses, where buyer and seller set aside extra funds to deal with any losses that might then occur. In order to do so, they need to use so-called clearing members - predominantly banks - to act as intermediaries between client and clearing house.

Herein lies a problem. The banking bit of the financial crisis was partly down to dodgy models that miscalculated the level of capital banks had to hold. To avoid this, regulators now insist on "leverage ratios" that more bluntly divide equity by a bank's total on and off-balance sheet exposures. Basel's initial take was that clients' clearing margins should be included in this leverage ratio denominator - thus pushing up the capital that lenders have to hold.

Reversing this - as is now being consulted on - would help ensure that the client members don't whack up the fees they charge. That would tally with the G20's underlying objective. Such a move would not be just good for the banks. Timothy Massad, the chairman of the US Commodity Futures Trading Commission, is worried about the effect on clearing if there isn't a rethink.

But if Basel bends, that is risky too. Thomas Hoenig, who sits a few blocks away from Massad in Washington DC at the Federal Deposit Insurance Corporation, has repeatedly warned of watering down derivatives regulation. He has a point: if clients' funds held to back trades prove insufficient, clearing members have to reach into their pockets to help sort the problem out. Softening the rules is sometimes defensible, but it's not without consequences.