Should We Swap Out Swaps Desks?

blanche_Lincoln.jpgWith even FDIC Chair Sheila Bair -- who, as primary regulator of small banks, has been a constant critic of Wall Street -- criticizing Sen. Blanche Lincoln's (right) plan to separate derivatives trading desks, also known as swaps desks, from major banks, it's time we take a closer look at the provision. It is Sec. 716 of this hybrid bill [PDF] that makes up the foundation of the financial-reform legislation.

The provision ends all bailouts and other federal assistance -- including routine access to the Federal Reserve's discount window -- to any institution that is a dealer in derivatives or runs a derivatives market. It's not intended, though, to actually end access to federal resources for these entities but rather to give the banks an offer they can't refuse: If you want to be a commercial bank that takes advantage of deposit insurance and the Federal Reserve, you can't have trade in highly complex, risky products like derivatives.

The big banks are up in arms over the proposal -- the five largest dealers, including J.P. Morgan and Goldman Sachs, would see curtailed profits in the billions of dollars under this arrangement, even more so than under the less controversial but still critical clearing and exchange requirements. There's also a general recognition that some of what banks do with derivatives to hedge risk -- including currency and interest-rate swaps -- is legitimate and banks ought to be able to do engage in those practices.

There are critics outside of the financial sector as well, including Bair, the Federal Reserve, and the Obama administration. They worry about a number of issues, including whether regulators will be able to supervise derivatives deals in affiliates created by banks to house their newly spun-off swaps desks as closely as they would if they remained within the bank. Regulators also worry that these new affiliates would carry less capital behind their deals than if they remained within their home institutions under the new legislation.

There's also an added question, if banks choose to divest more broadly, of whether this market will accrete into the darker corners of the financial world -- not so much abroad, although that is possible, but in the less-regulated hedge and private-equity fund markets.

Whatever happens in the Senate -- and it is unclear which senators will attempt to remove or amend Sec. 716 -- when House Financial Services Chairman Barney Frank comes to conference negotiations to reconcile the two chambers' versions of this bill, he'll have some suggestions to change it.

"He has talked about making sure that smaller ... regional banks don't get caught up in that, because some of them use derivatives to hedge against their own risk, their own loan books, interest-rate fluctuations, currency fluctuations," Frank's spokesperson, Steve Adamske, says. "He's not opposed to [the provision], but he thinks it needs to be refined."

-- Tim Fernholz

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