Monday, May 03, 2010

FDIC Chair Asks Senate to Remove Bank Derivatives Ban from Financial Reform Legislation

A provision in the Senate financial reform legislation prohibiting federally insured banks from trading in derivatives would have unintended consequences such as pushing swaps trading into harder to regulate hedge funds and futures commission merchants, in the view of FDIC Chair Shelia Bair. In a letter to Senate Banking Committee Chair Chris Dodd and Agriculture Chair Blanche Lincoln, the FDIC head noted that moving all derivatives market-making activities outside of bank holding companies would mean that such activities would still continue but in less regulated and more highly leveraged venues. Even pushing the activity into a bank holding company affiliate would reduce the amount and quality of capital required to be held against this activity. The swaps activity would then also be beyond FDIC scrutiny, she cautioned, since the FDIC does not have the same comprehensive backup authority over bank affiliates as it does over the banks themselves.

At the same time, the FDIC Chair expressed strong support for the enhanced regulation of OTC derivatives and the sections of the legislation that would require centralized clearing and exchange trading of standardized products. If this requirement is applied rigorously, she emphasized, it will mean that most OTC contracts will be centrally cleared, a desirable improvement from the bilateral clearing processes currently in use. She also supports the intent of the legislation to protect the deposit insurance fund from high risk behavior.

Section 716 of S. 3217 would prohibit federal assistance, including federal deposit insurance and access to the Fed discount window to swap entities in connection with their trading in swaps or securities-based swaps. This section would effectively require most derivatives activities to be conducted outside of banks and bank holding companies. In the letter, FDIC Chair Bair said that this provision would require $294 trillion in notional amount derivatives to be moved out of banks and bank holding companies that own insured depository institutions to hedge funds, futures commission merchants or foreign banks.

She also pointed out that the vast majority of banks that use OTC derivatives confine their activity to hedging interest rate risk with straightforward interest rate derivatives. Given the uncertainty surrounding interest rates and the detrimental effects movements could have on unhedged banks, the FDIC Chair urged the Senate to adopt an approach allowing banks to easily hedge with OTC derivatives. Ms. Bair believes that legislation directing standardized OTC derivatives towards exchanges or central clearing facilities would stabilize the OTC derivatives markets while still allowing banks to continue the important market making function they currently perform.

In her view, the underlying premise of Section 716 is that the best way to protect the federal deposit insurance fund is to push higher risk activities like derivatives into what the FDIC Chair called the shadow section of hedge funds and others. While acknowledging that speculative derivatives trading should have no place in banks, the FDIC believes that the Volcker rule addresses that issue and would be happy to work with the Senate on a total ban on speculative trading, at least in the credit default swap market. At the same time, other types of derivatives such as customized interest rate swaps and even some credit default swaps have legitimate and important functions as risk management tools, and insured banks play an essential role in providing market making functions for these products.

The FDIC reiterated that pushing derivatives trading to bank affiliates is not desirable since such affiliates would have to rely on less stable sources of liquidity, which, as was seen during the crisis, would be destabilizing to the banking organization in times of financial distress, which in turn would put additional pressure on the insured bank to provide stability. Concentrating derivatives trading in an affiliate of the insured bank could result in less and lower quality capital, less information and oversight for the FDIC, and potentially less support for the insured bank in time of crisis. Thus, in her view, Section 716 could actually weaken the Deposit Insurance Fund.

A central lesion of the crisis is that it is difficult to insulate insured banks from risk-taking conducted by their non-banking affiliated entities. When the crisis hit, noted the FDIC Chair, the shadow sector collapsed, leaving insured banks as the only source of stability. Far from serving as a source of strength, bank holding companies and their affiliates had to draw stability from their insured deposit franchises. She urged Congress not to reduce even further the availability of support to insured banks from their holding companies.