U.S. rule would shield failed banks from hedge funds in future crisis

WASHINGTON (Reuters) - Big U.S. banks would have greater protection from hedge funds in a future financial crisis under a Federal Reserve proposal released on Tuesday to require that some investors wait 48 hours before cutting ties with failing lenders.

The two-day pause is meant to prevent a chaotic unraveling of investments like what was seen during the 2008 financial crisis and failure of Lehman Brothers Holdings Inc.

At the time, desperate investors tried to void ties to Lehman after it sought bankruptcy protection, helping to spread panic in global financial markets.

The scene of derivatives investors desperate to unwind contracts could spur a modern-day run on a bank, Federal Reserve Chair Janet Yellen said on Tuesday, leading to "asset fire sales that may consume many firms."

Tuesday's proposal envisions a cooling-off period that could give banks time to transfer securities like derivatives to a healthy bank before bankruptcy, Yellen said.

Derivatives investors would have to acknowledge the 48-hour cooling off period in new financial contracts, according to the proposal, and existing contracts would also have to comply with the rule if the investment fund and bank continue to do business.

The Managed Funds Association, a voice for the hedge fund industry, expressed misgivings about the proposal.

"We ... remain concerned that reducing investors’ rights under the U.S. Bankruptcy Code would ultimately reverse decades of precedent designed to protect investors and the financial system, and would impair the fair and efficient functioning of capital markets," the association's chief executive officer, Richard H. Baker, said in a statement.

He said the group looked forward to continuing its dialogue with Federal Reserve officials.

Wall Street has until Aug. 5 to comment on the plan.

The new rule was envisioned as part of the Dodd Frank reform legislation and has backing from the Financial Stability Board, a global standard-setting panel for financial markets.

(Reporting by Patrick Rucker; Editing by James Dalgleish and Tom Brown)

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