The derivatives language that came out of the Ag Committee was surprisingly strong. So strong in fact that there’s suddenly been a lot of discussion about Senator Lincoln’s proposal to spin out swap dealers from bank holding companies. This language, if we were crafting a Glass-Steagall for the 21st Century, would be exactly how you would do it. And this language has come under a lot of criticism lately from regulators.
Since this was a brand new proposal that hadn’t been in the offering before, I wasn’t sure what to make of it. I was able to talk with Michael Greenberger about this. Michael Greenberger is a professor at the University of Maryland School of Law. In 1997, Professor Greenberger left private practice after more than 20 years to become the Director of the Division of Trading and Markets at the Commodity Futures Trading Commission. He currently serves as the Technical Advisor to the United Nations Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System. He has also been named to the International Energy Forum’s Independent Expert Group. He presented the derivatives chapter at the Make Markets Be Markets presentation.
Mike Konczal: What does Section 716, which has become one of the most controversial parts of the financial reform package, do?
Michael Greenberger: The bill bars any facility that is a dealer of swap contracts from being eligible for Federal Assistance. The most obvious bar would be that swap desks would not have access to the Federal Reserve discount window and would not be eligible for a bailout in the event of financial distress. As a practical matter, this is being construed as a requirement that the big 5 swap dealers — that is Goldman, Bank of America, Citi, JP Morgan and Morgan Stanley, who have over 90% of the swap market — would have to spin off their swap enterprises. Those swaps enterprises would then become independent facilities, outside of the bank holding company structure.
This is very much akin to the spirit of the Volcker Rule, which is trying to spin off the proprietary trading desk from bank holding companies.
Let’s say I run a large bank, and I lend out mortgages. I take on interest rate risk by doing this, and I want to hedge that risk with interest rate swaps. I obviously want a dedicated team to do this at a desk. Can I do this under the bill?
Absolutely! You could still hedge your interest rate risk by being a purchaser of swaps. This bill would not deny banks the right to purchase swaps; it would deny them the ability to sell swaps. A bank will have to go to an outside dealer to purchase swaps, rather than purchasing from an in-house swaps desk.
In fact, the benefit of this is that the oligopolist practices of the biggest banks would be compromised, and you’d see a lot more emphasis on the end-user experience. If banks weren’t in the business of marketing these products, but were still allowed to use them to legitimately hedge interest rate or currency risk, the focus will be on improving the benefits that flow to end users. Under this scenario, even banks will be encouraging regulation through transparency and capital requirements because they will be an end user not a dealer.
This could cause a lot more risk, because these independent facilities are now not regulated, where if they were in the bank they would be.
In the financial reform language being consider by the Senate and in the language as passed by the House in December 2009, even an independent swap desk would be fully regulated, to make sure they have adequate capital reserves, abide by prudential conduct standards, as well as strict business conduct standards. Ninety per cent of swaps trading will be required to go through a clearinghouse with an exchange facility, so there will be transparency and capital adequacy.
So having these enterprises outside of the institutions would not make them into shadow banks. They would still be fully regulated. And with a single business line, it might be easier to regulate properly, rather than having it embedded in the already confusing financial statements of these five massive banks. More importantly, it will remove very risky entities from bank-holding companies that have taxpayer-subsidized insurance.
Another worry is that if we did this, someone like Goldman would just revoke their bank holding charter, and become an investment bank again. I’m not sure if this is a real worry, because in theory they’d be regulated prudentially just like a bank under the Dodd Bill if they were deemed systemically risky.
If Goldman did that, all of Goldman would put its access to the Fed window in jeopardy – and that would be that as to taxpayer bailouts. Now I believe that there are provisions in the law that would prevent a bank holding company from walking away from banking oversight for no reason at all. But if Goldman is prepared for the entirety of its business to be denied access to taxpayer bailouts or the Federal Reserve relief, I say god bless. So would most Americans.
Another worry is that hedge funds and private equity would gobble up these enterprises, and become incredibly risky out of nowhere.
Again, that overlooks the fact that the swap desks themselves will be fully transparent to the government, will have to do regular reporting to the federal government, and will be required by the federal government to set aside adequate capital reserves appropriate to the riskiness of swaps trading.
As to the fear that hedge funds will buy swaps desks, even the proposed regulation in the pending legislation are not as draconian as that proposed for swaps desk. Hedge funds are not going to have capital reserve requirement and business conduct rules imposed upon them. The likelihood of hedge funds accepting the rigors of the swaps desk regulations is remote in the extreme.
What if we didn’t do this? Let’s say the largest players all had access to the Federal Reserve window, would that give them an unfair advantage over other swap desks that were not part of bank holding companies?
Yes, if the swaps desks remain within the holding companies, those dealers absolutely have an advantage over non-bank dealers. It’s a barrier to entry into a market that is already a highly concentrated market. The Justice Department already has an anti-trust problem with MarkIt, the pricing vehicle the five big swaps dealer banks control, which the anti-trust division is currently investigating. With these desks spun out, you are protecting the taxpayer, as well as keeping Goldman, Citi and others from having an advantage over others who want access to these markets.