Why Don't Banks Want Separate Derivatives Divisions?

Why are banks still complaining about having to spin off their derivatives desks if they don't have to? Last week, Sen. Blanche Lincoln (D-AR) clarified that her provision should be interpreted to mean banks would just have to put their derivatives desks into a separate affiliate from their depository bank. At first, this seemed like a much less significant change, since banks could still be in the business of derivatives, so long as the division creating swaps was separate from their deposits. As it turns out, even the newer interpretation of the bill would still be harmful to banks and the financial industry.

More Than a Logistical Problem

Derivatives businesses are highly dependent on capital and reputation: liquidity and a high rating convince investors and businesses that a bank is a safe counterparty risk. If financial reform requires banks to create a separate affiliate for derivatives, then this is more than just logistically annoying. Each bank would then need a new, separate highly capitalized division for this function.

Take banking behemoth JPMorgan, for example. The parent company JPMorgan Chase & Co. is rated Aa3 by Moodys. Its depository bank, JPMorgan Chase Bank, N.A. is rated Aa1. Its investment banking arm, JPMorgan Securities, Inc. is unrated. While you might think its derivatives desk falls under its securities division, it doesn't. If you want a swap with JPMorgan, it will be through its depository institution -- JP Morgan Chase Bank, N.A.

So JPMorgan can't just move its derivatives desk into its securities arm. It would also need a great deal of capital behind it and probably a rating. This is not only important from a counterparty perspective, but also in order to have the derivatives eligible for clearing. Big financial institutions do not want to have to capitalize another entity, but would rather rely on the capital in their bank to back their derivatives business.

Could Banks Still Hedge?

Andrew DeSouza, spokesman for the Securities Industry and Financial Markets Association, explains another worry. He says that financial institutions fear that the Senate bill in its current form would prohibit banks from hedging using derivatives. They worry that, even if they put their derivatives desk in an affiliate, the separate banks couldn't use any derivatives. If it did, then it could still be considered a swap dealer, and be forbidden from obtaining government assistance like depository insurance or use of the Federal Reserve's discount window.

Potential Solutions

It's a little unclear why even a separate derivatives division wouldn't be interpreted as having adequate creditworthiness, since it would sit below the broader holding company umbrella. If banks can find a way to reorganize and still have their broader institution's capital and rating behind their new derivatives divisions, then this problem would largely disappear. If not, then the problem would persist.

As for the hedging issue, that could be easily remedied through some explicit language in the bill that provides banks the ability to hedge. It's highly unlikely that the spirit of the financial reform bill means to prohibit banks from hedging in an end-user capacity -- when they have natural exposure to fixed rate loans through mortgages, for example. Otherwise, financial products would become more expensive for consumers, as a bigger risk premium would need to be built into prices, since hedging would be impossible.

At this point, it's becoming difficult to understand the logic behind why banks are required to separate their derivatives business. Despite their populist sneers they receive, derivatives actually do have a vital Main Street purpose. Unless the intent is to reduce derivatives to a true casino of bets between risky dealers, the industry should be structured to have as much stability as possible. Without any access to bank capital, derivatives would be on much shakier ground.