Thursday, May 06, 2010

Sen. Lincoln Defends Bank Ban on Derivatives Activities

Section 716 of the Senate financial reform bill prohibits federal assistance (including federal deposit insurance, and access to the Federal Reserve discount window) to swaps entities in connection with their trading in swaps or securities-based swaps. Section 716 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 remarks on the Senate floor, Senator Blanche Lincoln, the provision's sponsor, vigosously defended the prohibition, stating that it gets banks back to the business of banking and that these the derivatives activities, once pushed out of the banks, will not go to a dark corner but will be subect to SEC and CFTC regulation. Cong. TRecord, May 5, 2010, p. S3140.

According to Senator Lincoln, Section 716 has two goals. The first goal is getting banks back to performing the duties they were meant to perform, such as taking deposits and making loans for mortgages, small businesses, and commercial enterprise. The second goal is separating out the activities that put these financial institutions in peril. Section 716 makes clear that engaging in risky derivatives dealing is not central to the business of banking.

Sen. Lincoln refuted the suggestion that this provision will push derivatives trading off into the dark without oversight. The Dodd-Lincoln Title VII in the legislation makes it abundantly clear that all swaps activity will be vigorously regulated by the SEC and CFTC. Just because these swaps desks will no longer be overseen by the FDIC does not mean that they will not be subject
strong regulation by the SEC and CFTC under the Wall Street Transparency and Accountability Act, which has been codified as Title VII of the Restoring American Financial Stability Act.

Similarly, Sen. Lincoln refuted the suggestion that Section 716 will prevent banks from using swaps to hedge their risks. Banks that have been acting as banks will be able to continue doing business as they always have under the reform legislation, she assured, with banks using swaps still being allowed to hedge their interest rate risk on their loan portfolio. Most important, Congress wants them to do so. Banks offering a swap in connection with a loan to a commercial customer are also still in the business of banking and will not be impacted.

Sen. Lincoln said that using derivatives to manage risk and using them to create exotic swaps which have led to the financial demise are two very different things. Regulated, transparent swap activity is a necessary part of managing risk, she noted, but it has no place inside a bank where too many innocent bystanders are put at risk. By quarantining highly risky swaps trading from banking altogether, federally insured deposits will not be put at risk by toxic swaps transactions. Moreover, banks will be forced to behave like banks, focusing on extending credit in a manner that builds economic strength as opposed to fostering worldwide economic instability.