Bank Reform Bait and Switch

The Lincoln derivatives language tackles another set of issues. The major loss to banks is their inability to sell and trade without disclosing the prices they charge.

I asked Jane D’Arista, the former staff economist for the House Banking and Commerce Committees, whether a strengthened Volcker Rule was a fair trade for Lincoln. This makes it difficult to know the aggregate position of the bank or have adequate information about its risky trades,” says D’Arista. Even with requirements for clearing and trading standardized contracts on exchanges, it is easier to hide how much over the counter business they are doing using non-standardized contracts. But big banks would still be allowed to deal and trade on behalf of their clients and their derivatives business would still be backed by the taxpayer guarantee. Merkley-Levin would make this reform a statutory ban rather than leaving it to the discretion of regulators and would further crack down on Goldman-style conflict of interest trading. So why is it that Senate and House leadership are now busy behind these scenes trying to kill the best provisions in their own banking reform legislation?

When the Senate bank reform legislation passed in May, Senate Majority Leader Harry Reid said it sent the message to Wall Street “no longer can you recklessly gamble away other people’s money.” The bill told Main Street “you no longer have to fear that your savings, your retirement or your home are at the mercy of greedy gamblers in big banks. Neither is the U.S. “Right now the big banks make up 90 percent of the derivatives market. D’Arista helped walk me though the Lincoln reforms that are not addressed by the Volcker Rule or Merkley-Levin. The CFTC estimates that 90 percent of the derivatives market would be covered under the Senate version of the bill but only 60 percent under the House bill. “One of the real virtues of a separate derivatives affiliate is that it increases transparency. Treasury official Michael Barr has been running around telling anyone who will listen that these derivatives rules were not part of the administration’s four “core objectives” for financial reform. No other measure in the House or Senate bill does this. This is called propriety trading and banks would be barred from trading any financial instrument (mortgage backed securities and stocks as well as derivatives) for their own as opposed to a customer’s account. Lincoln’s proposal to force the big banks to spin off their derivatives desk would separate the risky business of marketing derivatives from the Federal Reserve window, FDIC insurance, and the taxpayer guarantee. And it says to them: never again will you be asked to bail out those big banks when they lose their risky bets,” according to Reid. D’Arista, who is a big supporter of both reforms, says the two measures are simply not interchangeable. It is hard to believe that Harry Reid will stand by and let the Treasury Department, Dodd and Frank gut the best parts of the bill that he lauded himself.

Protects States and Localities from Abusive Swaps: The Lincoln language contains a dozen other incredibly powerful safeguards including: a provision that would impose a “fiduciary duty” on a swap dealer entering into swaps with government entities such as states, municipalities and pension funds; a provision to allow regulators to prosecute persons who knowingly or with reckless disregard use false or misleading information to impact the price of any commodity such as food or oil; and a whistleblower protection program at the CFTC to encourage citizens to report fraud and abuse in the financial markets. In contrast, the Lincoln language forces these trades to be conducted by a stand-alone affiliate, regulated by the SEC and CFTC, that would be required to provide real-time information on its aggregate position and the volume and pricing of trades. The bill passed by the Senate did protect the taxpayers from reckless gambling by the big banks, largely due to the last minute inclusion of strong derivatives reforms authored by Senator Blanche Lincoln (D-Arkansas). When they put their trading desks into a separately capitalized affiliate, the huge capital reserves of the bank itself will no longer be there to back their enormous derivatives positions and the outsized scale of the derivatives market relative to the actual needs of commercial end-users. .

Behind the scenes, Senate Banking Chair Chris Dodd and House Financial Services Chair Barney Frank have made it clear they are not fans of Lincoln’s proposal.

Closes Major Loopholes: Another big plus is that the Lincoln language closes the $60 trillion foreign exchange swap loophole in the House version of the bill. Sign the petition today and let your member of Congress know how you feel about strong bank reform. Treasury Department. Campaign for America’s Future, CREDO and MoveOn are spearheading a “No Backroom Deals” campaign to force the conference committee to do its dirty work in the light of day.

Reid was correct.

Removes Taxpayer Liability for Wall Street Gambling: According to D’Arista the Lincoln language “lets banks be banks again.” D’Arista can’t understand why taxpayers are being forced to back up the business of marketing risky derivatives in the first place.

Unique Reforms in the Lincoln Derivatives Language

But these opponents of strong derivatives reform have a big problem. “There was no precedent or understanding in law or practice that this should be the case prior to the 2008 financial crisis when investment banks reorganized as bank holding companies to gain access to Federal Reserve bailout money,” says D’Arista. Bank affiliates could still serve bank customers. Lincoln’s proposal to force the big banks to spin off their derivatives desks into another, separately capitalized corporate entity is the top target of the big bank lobby which has spent $600 million so far in an attempt to defeat reform.

Engenders Competition and Reduces Risk: D’Arista says the Lincoln bill would also engender old fashion capitalist competition in the derivatives market. These derivatives would be treated like any other swap and be subject to mandatory clearing and exchange trading.

Ends the Shadow Market: Lincoln proposes to spin off the derivatives desks into separately capitalized affiliates. They will replace the Lincoln language with the strengthened version of the Volcker Rule offered (but never voted on) by Senators Merkley (D- Oregon) and Levin (D-Michigan).

On Wednesday, a House-Senate conference committee will begin work aligning the two versions of the bank reform bill. The smaller capital reserves of the affiliates will tend to shrink banks’ share of the market and open the door to other entrants.

“Zero Overlap” Between Proposals

House Majority Leader Nancy Pelosi said this week that she supports the Lincoln language and strong derivatives reform. They want to convince everyone that a strengthened Volcker Rule takes care of all the issues raised by Lincoln.

The Volcker Rule deals importantly, but narrowly, with derivatives trading for a bank’s own account. They are separate reforms designed to do very different things,” says D’Arista. If derivatives transactions occur within the bank, they are necessarily off balance sheet as a contingent liability or asset. They can’t just yank it out of the bill with an outcry from consumer advocates and reform groups like Americans for Financial Reform who have been working hard on the issue. “There is zero overlap between the prohibitions in the Volcker Rule and the Lincoln derivative desk push-out proposal. Plus it expands the list of counterparties in the system, reducing the risk to the financial system as a whole,” says D’Arista. So they have cooked up a new scheme

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