One of the stranger compromises coming out of the conference committee for financial reform was what happened with Sen. Blanche Lincoln's (D-AR) so-called spin-off provision. Initially, she would have forced banks to place all of their derivatives businesses into a separately capitalized subsidiary. Eventually, it was decided that trading in certain kinds of derivatives was okay, but not others. For example, banks can write derivatives based on gold, but not on platinum. Huh?
One theory for why this provision was changed is that some lobbyists got their way. Future exchanges are much better off if banks have a high barrier of participation for certain kinds of derivatives that became popular in the over-the-counter market more recently. But Friday, the Treasury had a conference call where it did a sort of victory lap for the financial regulation bill effort, providing a rare on-the-record opportunity for journalists to ask questions. So I asked about this:
I know the Blanche Lincoln spin-off provision got changed to wherein banks can retain certain sorts of derivatives business, such as interest rates swaps, foreign exchange, gold, silver, while they have to spin off other ones such as agriculture, metals other than gold and silver, and some other stuff. Can you kind of explain the logic there? Is gold and silver perceived as being less risky than platinum? Why are agriculture derivatives more risky than foreign exchange? What's the logic there?
Michael Barr, Assistant Secretary for Financial Institutions, responded:
I think the line that got drawn in the end on the Lincoln provision is a line that is based on the underlying asset that's being bought or sold, the derivative on that asset. And the line is not spelled out in statute as, gold is in and agriculture is out, but as based on the fundamental line between activities that are permissible for a bank, and activities that are not permissible for a bank. So if the underlying activity is one in which the bank could hold the underlying asset, then the derivative can be traded in the institution. And if not, then it needs to be pushed out. So it's based on the underlying principles in the National Bank Act about bank permissible activities.
This is a little bit confounding. So really, this provision isn't about reform at all. Reform, by its nature, should question the very foundation that something sits on -- not ask, "what would Abraham Lincoln do?" Financial reform was supposed to be about limiting risk in the financial system. But this provision isn't about risk at all. In this case, it went back to a 19th century Act for no reason other than, because the law created around the time of the Civil War said it's okay for banks to deal with gold, silver and currency, but not with platinum, corn or anything else. Should banks also ditch their computers in favor of abaci?
In a risk context, it's clearly absurd to say that it's safer for a bank to sell a derivative based on gold than one on platinum, for example. Remember, this law doesn't require that the bank holds enough of the underlying asset to be able to back up those derivatives -- just that it can hold that asset. Of course, banks can hold as much cash as they like, which is the medium of exchange for any assets anyway. That a bank isn't permitted to hold, say, cows, on its balance sheet doesn't mean it should be forbidden to deal cattle futures, but it's okay to trade euro futures, because it can hold currency.
What really isn't answered here is why the National Bank Act of 1863 matters in the context of creating a safer derivatives market. If reform is being defined as going back to old laws, then why wasn't Glass-Steagall reinstated? Maybe they should have eliminated the Federal Reserve and brought back the gold standard while they were at it. Why look like 1863 in one context and not another. Ultimately, this official response doesn't provide any theoretical framework. That's probably because this aspect of the bill stinks of lobbyists' perfume. There's no other rational way to explain it.
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