Lincoln's Swap Spin-Off Provision Begins to Evolve

The wheeling and dealing has begun as Congress' conference committee works to finalize the financial regulation bill. And the most controversial provision in the legislation is one of the first up for revision. The new rule, proposed by Senator Blanche Lincoln (D-AR), was originally intended to force banks to spin-off their derivatives desks. Opponents of the plan argue that it would ultimately hurt Main Street businesses, reduce lending, and make the derivatives market even riskier. Banks aren't getting their way yet, but reports indicate that the provision is being chipped away at.

According to Bloomberg:

Under the proposed new language, during the phase-in federal banking agencies would have two years to determine the impact of the measure on mortgage lending, small business lending, jobs and capital formation. The proposal does not provide for any action after the study.

We'll have to wait to see how this language actually turns out. But it sounds a lot like an amendment Senate Banking Committee Chairman Christopher Dodd (D-CT) offered at the eleventh hour, which would have revised the provision. The amendment was ultimately shelved, because no one liked it. The change also would have required a two-year study. But after that time, regulators could kill the provision. If the final bill reflects the same power for regulators, then you could expect them to eliminate the new rule, since they broadly agree that Lincoln's requirement would harm the financial industry.

Also:

The revised language being considered by Lincoln would clarify that banks with access to Federal Deposit Insurance Corp. deposit guarantees and the Federal Reserve's discount lending window would be allowed to hold a separately capitalized swap dealer in an affiliate of the bank holding company.

So there won't exactly be a spin-off, just a forced placement into a separately capitalized subsidiary.* This was actually how Lincoln claimed that she intended the provision to function in May, when banks began complaining loudly about it. So this is more a clarification than an explicit change -- but banks will no doubt be a little relieved they can still trade derivatives.

Yet they'll still be unhappy. They will have to raise a huge amount of capital to provide a cushion for these new divisions. Their complaints are explained in detail here.

It's a little hard to understand how having a derivatives desk in a separate affiliate under a bank holding company umbrella captures the essence of the original legislation's intent. If the goal is to create a market where federal bank bailouts could never be necessary due to derivatives, then it fails. Even if the new rule passes, a bank holding company could still, in theory, need a bailout because its separately capitalized derivatives division runs burns through its capital base and threatens the institution's stability. Just ask AIG.

If this provision survives in a meaningful way, it would be quite surprising. It will also be quite detrimental to the financial industry, and ultimately, the U.S. economy. A great deal of derivatives business would travel overseas. Banks would need massive amounts of capital in these new subsidiaries which would limit how much money they have available for lending.

*Update: A reader asked that I explain this distinction better. In a sense, retail banking divisions would still have to spin-off their derivatives business into a separate affiliate under the bank holding company. But that's different from saying the holding company itself has to be out of the business entirely. So banks like JPMorgan and Goldman Sachs could still trade derivatives, but they'd have to use a separately capitalized division to do so.