Senator Lincoln Proposed Segregating Derivatives Units of Commercial Banks

Bloomberg reports that Senate Agriculture Committee Chairman Blanche Lincoln is expected to table a proposal to require commercial banks to separate their derivatives operations from their commercial banking activities. The intent is to prevent banks from using cheap deposits to subsidize risky derivatives businesses, and thus eliminate the government backstopping of these activities. This “no bailout provision” would also forbid banks to use emergency banking facilities like the discount window and FDIC emergency liquidity guarantees for their derivatives activities.

As appealing as this idea sounds, I’m skeptical as to whether it will solve the systemic risk posed by over-the-counter derivatives businesses, in particular credit default swaps (plain vanilla interest rate and foreign exchange swaps are much less problematic). On the one hand, ending the ability to use cheap deposit funding to support derivatives operations should raise the cost of providing these products and hence somewhat reduce the size of the market. On the other hand, securities firms like Goldman, Morgan Stanley, and Merrill Lynch, which did not enjoy deposit subsidies pre-crisis, were also participants in these businesses, which suggests that the impact of use of deposit funding on the economics of these businesses may not be as great as some would like to believe. Moreover, the Fed extended emergency support to non-banks deemed systemically important, namely the former investment banks plus AIG. Pretending that segregating derivatives operations means the government won’t run to their rescue in a crisis looks like wishful thinking.

But the bigger issue is that this proposal is likely to be watered down into meaninglessness by the industry. European banks like SocGen, Paribas, UBS, and DeutscheBank, are large derivatives players and have long operated as universal banks, meaning deposits can fund any and all balance sheet needs. Unless European regulators are prepared to adopt similar rules, the major US players are certain to howl that their competitive standing will suffer and they therefore need to have the same privileges as Eurobanks.

From Bloomberg (hat tip Tim C):

Lincoln’s bill is tougher than what Obama has proposed for derivatives oversight and could complicate efforts to pass a broader regulatory overhaul bill, lawmakers said yesterday. It would have to be approved by the Agriculture Committee and then incorporated into the broader regulatory-reform bill drafted by Senate Banking Committee Chairman Christopher Dodd. Dodd’s was approved by the banking panel last month on a 13-10 vote without Republican support…

Senator Judd Gregg, a New Hampshire Republican, expressed frustration that a deal between Lincoln and Senator Saxby Chambliss of Georgia, the Agriculture panel’s top Republican, had fallen apart under White House pressure. Gregg indicated the derivatives bill wouldn’t get Republican support…

The proposal, which would affect 25 to 30 banks that trade derivatives, is likely to generate strong opposition, analysts said. Along with Goldman Sachs and JPMorgan, the other three banks that control almost all swaps trading are Morgan Stanley, Citigroup Inc. and Bank of America Corp.

Originally published at Naked Capitalism and reproduced here with the author’s permission. 

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