Shoring Up Lincoln Swaps Plan

RPT-U.S. Congress Dems shoring up Lincoln swaps plan
9:16am EDT


By Kevin Drawbaugh and Charles Abbott

WASHINGTON, June 16 (Reuters) - Democrats were working on Wednesday to bolster a plan that would force big banks to spin off their swap dealing desks, with backers of Senator Blanche Lincoln's controversial proposal aiming to push forward.

In the face of opposition from Wall Street, the Senate Banking Committee was seeking to tighten Federal Reserve rules to address concerns some lawmakers have about isolating swap dealing units from the banks that spin them off, an aide said.

The Fed's "arm's length" rules are supposed to limit risks posed to a bank from transactions between it and its affiliates. The rules have been set aside in years past and are a weakness in Lincoln's plan, according to some aides.

Strengthening them would draw more support from Democrats, many of whom want something like Lincoln's plan to be in the sweeping Wall Street reform legislation that is being finalized by a Senate-House of Representatives conference committee.

The Lincoln proposal is "moving along and it's moving along in the right direction," Democratic Senator Jack Reed told Reuters in an interview after a meeting of the committee.

"The critical issue now is, if you're going to move this derivatives trading, is it all the way out of the holding company, or is it within an affiliate? We're still struggling with that," said Reed, a conference committee member.

Swaps are derivative financial contracts that let their users hedge against risks of changing interest rates, exchange rates or, in the case of credit default swaps, or CDS, the likelihood of a borrower defaulting on its debts.

The $615-trillion market for derivatives traded off-exchange is dominated by a handful of big Wall Street banks, including Goldman Sachs (GS.N: QuoteProfileResearch,Stock Buzz), JPMorgan Chase (JPM.N: QuoteProfileResearchStock Buzz), Morgan Stanley (MS.N: QuoteProfileResearchStock Buzz), Citigroup (C.N: QuoteProfile,ResearchStock Buzz) and Bank of America (BAC.N: QuoteProfileResearchStock Buzz).

Lincoln has proposed that these banks and others be forced to separate swap dealing and banking. The idea is to reduce the likelihood of more bailouts, like those seen in the 2008-2009 crisis, by preventing swap markets from jeopardizing the safety of banks backed by taxpayers.


When she first unveiled her proposal earlier this year, it was widely interpreted as calling for banks to completely separate themselves from their swap trading desks.

On Monday, she issued a "clarification" that said banks could spin off their swap dealing into separately capitalized subsidiaries still within their holding companies.

She also said banks themselves could continue to be swap market participants, using off-exchange derivatives to hedge their own risks and offering the same services to customers.

However, Senate aides said the most important part of the "clarification" was that spun-off dealing desks could remain in the bank holding company. That raised questions about how isolated they would truly be from the bank, the aides said.

"JPMorgan is a $2-trillion bank with an $80-trillion derivatives exchange out back," said one aide.

"I don't care whether that's sitting on top of the bank or sitting on top of some bank-holding company sub, if it goes ka-boom, you're still going to hit the bank."

The Fed's arm's length rules, known as 23A and 23B, are supposed to protect banks from affiliates' problems.

"But historically the 23A and 23B firewalls drop every time a crisis hits," the aide said.

Firming up those rules looks likely to be key to the Lincoln's plans prospects.


"The only problem with Senator Lincoln's derivatives amendment is that it does not go far enough to drive toxic derivatives out of the bank holding company temple entirely," said Boston University Law School Professor Cornelius Hurley.

"By lodging this casino activity in bank holding company affiliates, she runs the risk of the Fed doing in the next crisis exactly what it has done in this one, namely waiving the rigid rules that are supposed to separate banks from their holding company affiliates," Hurley said.

In a related development, a spokesperson for St. Louis Federal Reserve Bank President James Bullard said on Wednesday that he supports Lincoln's plan.

Fed Chairman Ben Bernanke has expressed concern with the proposal. So have many moderate House Democrats and Democratic Representative Barney Frank, conference committee chairman.

When the committee finishes its work, likely by the end of the month, the Lincoln plan or something like it will probably be in the final bill, said Michael Konczal, a fellow at the Roosevelt Institute, a policy think-tank.

He said it was unclear how much better banks would be protected from risks if swap dealing desks were spun off into affiliates still housed inside holding companies.

"At the end of the day, we won't know until we're in the middle of the next crisis," Konczal said. (For a Factbox on new tweaks to Lincoln's plan, double-click on [ID:nN14223826]) (Additional reporting by Mark Felsenthal in New York; Editing by Jan Dahinten)

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