The Danger in Forbidding Banks from Dealing Derivatives

One of the most talked about -- and controversial -- new rules in the Senate Agriculture Committee's new derivatives bill would require banks to spin off their derivatives desks. Reports indicate that the rule made it into Senate Democrats' final version revised on Sunday. While it sounds like a fine idea for banks to simplify their businesses by not dealing derivatives, the provision would harm the market.

Perusing the Ag bill (.pdf), you won't find any language explicitly calling for banks to spin off their derivatives business. That's because this would be an indirect consequence caused by another provision which would forbid federal assistance for an institution that engages in the derivatives business. Without being able to utilize Federal Depository Insurance Corporation funds or emergency loans from the Federal Reserve, banks will feel they have no choice but to spin off their derivatives desks. This is a strange sort of indirect way to require banks to get out of the business of derivatives. The legislation could have instead simply forbid depository institutions from dealing derivatives. This indirect method gets there too, but only in a round-about way.

In theory, a bank could choose to continue dealing derivatives and opt out of being eligible for government assistance. But there's little chance any depository institution could afford to shed its FDIC charter. The once traditional investment banks that obtained a bank holding company status so to gain access to the Fed's emergency funding during the crisis -- including Goldman Sachs and Morgan Stanley -- might decide to rethink that move if the rule is passed. The thought of losing their lucrative derivatives businesses could cause them to choose to revert back to traditional investment banks.

It's also useful to note that the institutions which were the biggest problems during the crisis -- Lehman Brothers, Bear Sterns, Merrill Lynch, AIG and Fannie/Freddie -- were not depository banks who would have qualified for such assistance. The provision would not have prevented these institutions from trading derivatives. As a result, in all likelihood, it would have had no effect in preventing the financial crisis.

Forcing banks to spin off their derivatives desks would devastate the banking industry and put U.S. firms at a significant disadvantage in the global financial market. One of the most important characteristics of a swaps dealer is its capital adequacy and creditworthiness. Counterparties and clearing houses will want to be comfortable that swap dealers won't default. With this provision, non-U.S. banks that are still permitted to deal derivatives will have a significant advantage for this reason.

If a derivatives desk doesn't have a bank behind it with lots of capital to better ensure its survival, the market will become less efficient. Large amounts of collateral will have to be posted for trades, and derivatives will become much more expensive. While it may be prudent to reduce the derivatives market to some extent, these new rules might go too far. Despite their recent bad press, derivatives serve an important function in both business and banking.