Behind an Estimated $30 Trillion Drain on Banks, a Lot of Hypotheticals

Imagine a situation in which the world’s banks have to find as much as $30 trillion to comply with just one new regulation. That might be something of a stretch, given that the gross domestic product of the United States is only $15.8 trillion, and the world’s 10 largest banks hold only $25 trillion of assets.

Yet a banking industry group recently looked into a new rule and sketched out a possibility in which banks were forced to come up with as much as $30 trillion in cash.

The potential cash call is outlined in a letter the International Swaps and Derivatives Association sent in September to regulators. It is the latest eye-popping number that lobbying firms and banks have produced to support their view that many new regulations will be enormously expensive — and the big, scary numbers seem to be gaining traction.

Some of the concern may be warranted, especially in Europe, where certain stressed banks have had trouble borrowing regular amounts in the markets. But a deeper look at the industry association’s $30 trillion figure suggests that many of the worries might be overdone.

The gargantuan sum relates to the market for derivatives, which are financial contracts that banks and investors use to bet on interest rates, stock prices, creditworthiness of corporations and the like.

Derivatives played a central role in the 2008 financial crisis. The market for many contracts was opaque, which stoked panic when certain players started to falter.

Before the financial crisis, big participants like large Wall Street banks were often able to avoid following certain rules intended to make the market safer. One of those practices involves something called initial margin. This is the cash or easy-to-sell assets that parties have to set aside at the outset of a derivatives trade. If one side can’t pay up, the other side can make a claim on the initial margin.

Now, regulators want to tighten up the margin rules. To do so, they are introducing regulations aimed at pushing derivatives trades through entities called central clearinghouses. These organizations effectively agree to pay out if one side of the original trade cannot pay.

Because of that pledge, clearinghouses have to make sure they can pay out if one party defaults. One way they do this is to demand margin from the parties that trade through them.

But a large number of derivatives trades won’t necessarily go through clearinghouses, even after the overhaul is in place. Such trades will still be done directly between two financial firms.

Regulators have proposed rules that force firms to supply initial margin on these so-called bilateral trades, too. These rules, which won’t apply to pre-existing trades, may not come into effect until late 2013 in the United States.

The International Swaps and Derivatives Association and many others want to stop or water down those margin rules on bilateral trades. In its paper, the association argued against initial margin rules, saying they were “likely to lead to a significant liquidity drain on the market, estimated to be in the region of $15.7 trillion to $29.9 trillion.” In other words, it believes there is a possibility that the rule could cost $30 trillion.

So, how likely is such a drain? A clue can be found in the $14 trillion range in the association’s estimates.

Under its lower estimate, the industry group assumes that many banks calculate their derivatives exposures in an advantageous manner sanctioned by the proposed regulations. Specifically, the rules allow banks to offset certain trades with each other. This has the effect of reducing a bank’s overall derivatives exposure for the purposes of calculating margin.

The upshot: Less margin is needed. At one stage in its analysis, the derivatives association says using this approach might reduce by half the overall amount of derivatives in the calculation.

But why wouldn’t the reduction be far more than $14 trillion, or roughly 50 percent? After all, net exposure can be reduced quite sharply by using the offsetting method. For instance, a bank may have $50 billion on trades betting that stocks go up and $49 billion on trades betting stocks go down, leading to a $1 billion net exposure for the bank.

Steven Kennedy, a spokesman for the association, says it chose 50 percent based partly on its estimates of how many firms might have the required technology to carry out offsetting. In essence, the numbers involve a lot of hypothetical assumptions.

This weakness applies to other, lower-margin estimates from opponents of the new rules.

Last year, the Office of the Comptroller of the Currency, a federal bank regulator, estimated that initial margin rules could lead to a $2 trillion burden for banks, a smaller but still alarming figure. The number was cited in several letters and studies from lawyers and lobbyists arguing against the margin rule. The comptroller listed three factors that might lead to banks posting less than $2 trillion. But, the study added, “at present, we are unable to estimate the mitigating effects of these three factors.”

Bryan Hubbard, a spokesman for the comptroller, said the paper reflected the comptroller’s best analysis at the time. He added, “The O.C.C. is likely to update the analysis when a final rule is issued.”

Other opponents of initial margin rules have been similarly vague when gauging factors that might reduce the burden. JPMorgan Chase sent a letter last year to regulators criticizing the initial margin rule, saying it might need to collect $1.4 trillion from its trading partners if it did not use the offsetting approach. The letter did say an offsetting approach might “produce smaller initial margin amounts.” Still, it didn’t specify how much smaller.

The initial-margin rules may prompt some firms to stop doing bilateral derivatives trades. Some financial companies have even started down that path.

In the face of new margin rules, Berkshire Hathaway said this year that it would not be entering any big new derivatives bets. “We shun contracts of any type that could require the instant posting of collateral,” Warren E. Buffett, the company’s chief executive, wrote in its latest annual report.