Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation, defended the inclusion of certain exposures of banks to cleared derivatives, including through the clearing activities of their futures commission merchant affiliates on behalf of customers, in the calculation of their so-called “leverage ratio,” in a speech before the Exchequer Club of Washington, DC, on September 16, 2015. (The leverage ratio refers to the amount of shareholder equity and disclosed reserves a bank maintains divided by its total exposures. Under Basel III, banks are expected to maintain a leverage ratio of 3 percent while the Board of Governors of the Federal Reserves expects most insured bank holding companies to maintain a leverage ratio of 5 percent, and the systematically important financial institutions 8 percent.) According to Mr. Hoenig, “…the clearing mandate [was] not a mandate to weaken the prudential regulation of banking organizations as a means to stimulate the derivatives business.” Mr. Hoenig rejected the argument that cash received from an FCM’s customers for initial margin should be excluded from a bank’s calculation of its exposures because an FCM only acts as an agent for its clients. This is not the case, said Mr. Hoenig, because FCMs can ordinarily invest customers’ cash deposits and earn income. However, Mr. Hoenig indicated that a bank could exclude customers’ cash deposited as initial margin with an FCM affiliate if the agreements between the customers and the FCM eliminated “any right to investment income from the collateral.” Mr. Hoenig noted that “[s]ome institutions have done this.” However, Mr. Hoenig proposed no means for a bank to exclude from its total exposure calculation affiliated FCMs’ guarantee of client performance to clearing houses. According to Mr. Hoenig, "[s]uch guarantees, whether for derivatives or other obligations, are included in the leverage ratio to ensure that banks do no move significant sources of exposure off-balance sheet."

My View: Most importantly, in his speech, Mr. Hoenig acknowledged that banks can reduce some of the deleterious impact of the leverage ratio caused by their affiliated futures commission merchants if their FCMs agree to forego earning investment income on customer cash deposits. This can be accomplished through amendments to customer agreements (he does not contemplate any amendments to law or rules). According to Mr. Hoenig, “[i]f the resulting contract ensures the FCM truly is acting merely as an agent, it need not record an asset.” Moreover, Mr. Hoenig suggested that the FCM could even retain the economic impact of the investment income by having the client retain “…the income on the invested funds and then [paying] a fee to the clearing member.” Although this appears to be a practical fix to at least some of the tsuris caused by application of the leverage ratio to FCMs’ clearing business, it is premised on a fallacy. According to Mr. Hoenig, “[a]s substantial as derivatives risks were [during the 2008 financial crisis] to the broader economy, they remain no less substantial, opaque, and interconnected today. If anything the case for more capital is greater today.” It is not clear why Mr. Hoenig claimed that transparency is still an issue for all derivatives when, in the United States, as recently as the second quarter of 2015, almost 75 percent of all average daily notional volume of interest rate derivatives and CDS index markets were centrally cleared and information on all cleared and non-cleared swaps are now mandated to be reported.