EU wants Lehman-proof capital requirements

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The European Commission wants to raise the amount of capital held by its banks to shield against losses incurred by derivatives trading, such as those which brought Lehman Brothers to a standstill in 2008, according to a paper.

Yesterday (9 February) the European Commission released a consultation paper showing that it wants to see more capital on banks' books to insure against Lehman-style losses incurred in risky derivative deals.

The Lehman collapse was a wake-up call for regulators and bankers that all was not well with derivatives trading, a $600 trillion global market based on the future price of the assets they are linked to.

Upping capital requirements has been regulators' intention for some time, not least because it has grown out of discussions at the G20. Now the industry has exactly one month to tell the Commission what kind of rules they could live with.

Derivatives expose investors to counter-party risk which means that one party – a client or a broker – may not be able to honor their side of the deal.

The European Commission has already put forward proposals to drive derivatives trading onto exchanges to ensure that they are overseen by central counterparties (CCP).

The Commission hopes this would prevent a Lehman-style ripple effect by allowing counterparties to intervene if either side cannot pay. Typically derivatives are cleared and settled by the client and the broker alone.

The EU consultation paper also suggests using penalties to force derivatives traders to use CCP clearing houses or banks to hold more capital, something which is expected to ramp up their business costs and trim profits.

Since the collapse of Lehman Brothers in 2008, counterparty risk became a growing concern for the industry. A counterparty is simply one side of a transaction, either a broker or a client, and the risk is that they will not honour payments.

The industry suspected that derivatives - a $600 trillion global market based on the future price of the assets they are linked to- carried a lot of counterparty risk, which was confirmed by the Lehman collapse in 2008.

The European Commission has already put forward proposals to drive derivatives trading onto exchanges to ensure that it is overseen by central counterparties who could intervene before any damage is done.

Upping capital requirements has been on the EU's agenda for a long time and has been driven by both the Basel Committee on Banking Supervision (BCBS) – a group of central bank governors – and the latest G20 summits on financial supervision.

Between February and April 2010, the Commission services conducted a public consultation on possible further changes to the Capital Requirements Directive (CRD), which broadly followed the preliminary proposals put forward by the BCBS published in December 2009.

Yesterday (9 February) the European Commission launched another consultation to examine capital requirements for counterparty credit exposures arising from derivatives. 

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