Banks agree derivatives rule to end 'too big to fail' scenario

The US$700 trillion financial derivatives industry has agreed to a fundamental rule change from January to help regulators to wind down failed banks without destabilising markets.

The International Swaps and Derivatives Association (ISDA) and 18 major banks that dominate the market will now allow financial watchdogs to apply temporary stays to prevent a rush to close derivatives contracts if a bank runs into trouble, the ISDA said.

A delay would give regulators time to ensure that critical parts of a bank, such as customer accounts, continue smoothly while the rest is wound down or sold off in an orderly way.

That would help to avoid the type of market chaos sparked by the collapse of one of America's biggest institutions, Lehman Brothers, in 2008 and also end the problem of banks being considered too big to fail.

The Financial Stability Board, a regulatory task force for the Group of 20 economies, had asked the ISDA to make the changes with the aim of ending the too-big-to-fail scenario in which banks are propped up with taxpayer money to avoid market disruption.

Under the new contract terms, default clauses in derivatives contracts such as interest rate or credit default swaps would be suspended for a maximum of 48 hours.

"Ending too-big-to-fail is going to be an evolutionary process, but the agreement of the first wave of banks to sign the protocol is a big step forward," ISDA chief executive Scott O'Malia said.