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. 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.
Reid was correct. 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). 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?
Watch the Hands
On Wednesday, a House-Senate conference committee will begin work
aligning the two versions of the bank reform bill. 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.
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. Neither is the U.S. Treasury Department.
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.
But these opponents of strong derivatives reform have a big problem.
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. So they have cooked up a new scheme.
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). They want to convince everyone that a
strengthened Volcker Rule takes care of all the issues raised by
Lincoln.
"Zero Overlap" Between Proposals
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. D'Arista, who is a big supporter of both
reforms, says the two measures are simply not interchangeable. "There is
zero overlap between the prohibitions in the Volcker Rule and the
Lincoln derivative desk push-out proposal. They are separate reforms
designed to do very different things," says D'Arista.
The Volcker Rule deals importantly, but narrowly, with derivatives
trading for a bank's own account. 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. 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.
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.
The Lincoln derivatives language tackles another set of issues.
D'Arista helped walk me though the Lincoln reforms that are not
addressed by the Volcker Rule or Merkley-Levin.
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. "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. 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. No other measure in the House or
Senate bill does this.
Ends the Shadow Market: Lincoln proposes to spin off
the derivatives desks into separately capitalized affiliates. "One of
the real virtues of a separate derivatives affiliate is that it
increases transparency. If derivatives transactions occur within the
bank, they are necessarily off balance sheet as a contingent liability
or asset. 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. This makes it
difficult to know the aggregate position of the bank or have adequate
information about its risky trades," says D'Arista. 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. Bank affiliates could still serve bank customers.
The major loss to banks is their inability to sell and trade
without disclosing the prices they charge.
Engenders Competition and Reduces Risk: D'Arista
says the Lincoln bill would also engender old fashion capitalist
competition in the derivatives market. "Right now the big banks make up
90 percent of the derivatives market. 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. The smaller
capital reserves of the affiliates will tend to shrink banks' share of
the market and open the door to other entrants. Plus it expands the list
of counterparties in the system, reducing the risk to the financial
system as a whole," says D'Arista.
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. These derivatives would be treated
like any other swap and be subject to mandatory clearing and exchange
trading. 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.
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.
House Majority Leader Nancy Pelosi said
this week that she supports the Lincoln language and strong derivatives
reform. 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.
No Backroom Deals
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. Sign the petition today and
let your member of Congress know how you feel about strong bank reform.