UK and U.S. watchdogs probe bank collateral

LONDON (Reuters) - Financial watchdogs in London and New York have launched a review of investment banks' management of collateral to see how they would withstand a crisis, the FSA's head of wholesale banking said on Tuesday.

Investment banks use collateral from clients, such as hedge funds, as a cushion against any potential difficulties or losses. Hedge funds, for example, have to provide collateral to investment banks that lend money to trade stocks or bonds.

"We want to kick the tires," said Thomas Huertas, the Financial Services Authority's director of wholesale firms at the Reuters Investment Banking Summit in London.

"We are coordinating the work with other regulators such as the New York Fed."

The FSA's move to scrutinize collateral management follows a survey on investment banks' exposure to hedge funds, completed last year.

Hedge funds have become big money spinners for investment banks, accounting for nearly $30 billion in revenues in 2004, according to analysts' estimates.

Banks are requiring collateral for an increasing number of complex structured products.

Use of collateral in privately negotiated derivatives transactions hit $1.439 trillion by March of this year, according to the International Swaps and Derivatives Association (ISDA).

That was a 19 percent increase over the $1.209 trillion of collateral in circulation in the previous year, ISDA said, with some 59 percent of derivatives transactions covered by collateral, compared with 55 percent in 2005.

The FSA's hedge fund survey found banks were relatively well collateralized, but the FSA now wants to go one step further to test how quickly the banks could get their hands on collateral if they needed it in a hurry.

"We need to be sure that banks have the right type of agreements in place ... and can execute in the right time frame," Huertas told Reuters previously.

For example, the regulator will look at legal agreements covering collateral to see whether a bank would actually own the collateral if it needed to use it.

Also timing is crucial. A bank might need to call in the collateral quickly, but complex legal requirements in its collateral agreement could cause delays.