How Will Blanche Lincoln's Primary Affect Financial Reform?

Do democrats in Arkansas control the future of derivatives? They're voting today in a primary runoff between Senator Blanche Lincoln and Bill Halter. This matters because Lincoln is the author of the controversial derivatives section in the Senate's financial reform bill. It's far more aggressive than what the House demanded. But if she loses, might this mean the end for her derivatives provision as well?

In the legislation, Lincoln calls for stricter rules for putting derivatives through clearing and on exchanges. But the part that really has bankers shaking in their Gucci loafers would require derivatives businesses to be spun off into new subsidiaries, which would need their own capital. Lincoln drafted this tough provision in order to try to soak up more of the progressive vote in her Arkansas primary.

But recent polls indicate that it might not be working. Although the vote will be close, Real Clear Politics polling shows Halter up four points. Politico says, if Lincoln loses, the spin-off provision might suffer:

If Lincoln loses the too-close-to-call race to Lt. Gov. Bill Halter, some on Wall Street think it will be easier to get the language out. But no matter how the primary turns out, the overwhelming confidence Wall Street once had that the provision would be gutted has largely evaporated.

And the price to be paid if Lincoln's derivatives language does come out--widely expected to be a tougher version of the "Volcker rule" banning proprietary trading--could make it a hollow victory, financial executives and lobbyists said.

"It now looks like we are going to get a tougher Volker [rule] as the price we pay for getting rid of Lincoln," one industry official said. "That's something that has changed in the last few days."

Although Wall Street's pessimism is duly noted, it would be quite surprising if the spin-off provision made it into whatever bill President Obama eventually signs.

First, Lincoln's decision to call for this was always purely political. That's why, at the eleventh hour, Senate Banking Committee Chairman introduced an amendment that would have essentially killed it -- so to minimize the blow to her campaign. That amendment didn't end up getting offered, because Republicans didn't like it much after all. But it's pretty clear that Dodd never intended to have Lincoln's spin-off provision in the final bill.

Second, virtually every major regulator is against this requirement. Those opponents include the White House (and Treasury), FDIC Chair Sheila Bair, Fed Chair Ben Bernanke, and Former Fed Chair Paul Volcker. It's not entirely clear where House Financial Services Chairman Barney Frank stands. But since his knowledge and understanding of the financial industry should make him well aware of damage the provision would do, it's hard to believe that he would allow it to live in the final bill.

Third, even if Frank does go along, it's not guaranteed that a majority in the House would go for it. Remember, the House bill passed by only five votes. That bill did not contain anything as aggressive as requiring banks to spin off their derivatives businesses. So the House leadership may worry that they could lose a few votes if this provision is included, jeopardizing the entire financial reform effort.

With all that said, it's possible that Democrats will use the provision for leverage, threatening to include it if the Volcker rule isn't strengthened, as Politico indicates. That may be a bluff, but it could work. The big question is whether the Volcker rule will take the form in the Senate bill or House bill. And if Politico's sources are right, then it would take the Senate's version, which is slightly more aggressive.

If Lincoln wins, however, the situation is probably the same. Given that she's down 25 points on her republican candidate John Boozman, according to Real Clear Politics, it's not likely she needs to court the progressive vote to win. She would need moderates and conservatives, who aren't likely to be impressed by a provision that some of them may realize will ultimately hurt U.S. competitiveness in financial services.