Blanche Lincoln's Ag Bill Won't Require Banks to Spin Off Derivatives?

In a strange turn of events, Sen. Blanche Lincoln's office (D-AR) now says that the most controversial section of her derivatives bill (.pdf) would not force banks to spin off their derivatives desks. The Wall Street Journal reports that she wants to allow bank parent companies to remain in the derivatives business, but to put that function in a subsidiary separate from its consumer banking. This changes everything.

It's a little suspicious that this announcement has been only made now. For weeks, journalists, economists, bankers, and politicians have been talking about the effect on the market spinning off derivatives desks would have. Why did Lincoln wait so long to correct them? Did she decide to reinterpret her own bill due to the controversy that ultimately surrounded it? After all, even the Obama administration thought this proposal went too far.

The provision grows out of the bill forbidding any federal assistance (like depository insurance) for any bank that deals derivatives. Apparently Lincoln only intended to deny assistance for a subsidiary -- not the whole institution? What's the point?

Under the earlier interpretation of the provision, the motivation appeared to be that banks would be safer without derivatives. But if its parent still has a securities firm under its umbrella, then it could again run into trouble due to its derivatives desk if things go bad. Think about AIG. In that case, its financial products division caused most of its massive losses. Even if that was a separate subsidiary from its life insurance group, AIG would still have been in trouble on a whole.

Moreover, if a bank holding company then gets assistance, say an emergency loan from the Fed, what's to stop it from using that money to recapitalize a derivatives subsidiary that has sustained large losses? After all, money is fungible.

According to the WSJ, big banks will still be unhappy about this change, because it will force them to put new capital into its new derivatives affiliate. This supposed reaction is unlikely.

First, many, if not all, big banks already have their securities arm separate from their consumer bank. The securities division wouldn't be the one that requests federal assistance like depository insurance, so banks may not have to shift anything around at all in most cases.

Second, the market will likely be perfectly comfortable if these separate derivatives desks aren't that well capitalized on their own. After all, that's how it's always worked. Obviously, if the desks incur a big loss, then the parent will ultimately have to back them up. Capital structure won't likely have to change in any significant way.

Whatever the real reason for Lincoln's reinterpretation of this provision, critics will likely welcome her change of heart. Banks won't be required to spin off their derivative desks -- they'll just have to keep them separate from their depository banks. The original interpretation would have endangered market stability, but the reinterpretation won't result in a significant change.