Thursday, April 26, 2012

House Passes Legislation Extending Dodd-Frank Swap Exemption

The House passed by an overwhelming bi-partisan vote legislation to ensure that smaller financial institutions can continue to provide and use risk management tools that facilitate the flow of credit throughout the economy. The Small Business Credit Availability Act, HR 3336, would amend the Commodity Exchange Act to clarify that insured depository institutions and Farm Credit institutions will not be swap dealers to the extent the institution enter into swaps with customers seeking to manage risk in connection with an extension of credit by the institution.

The Act would amend the Commodity Exchange Act to exclude from the definition of financial entity small banks, savings associations, farm credit system institutions, non-profit cooperative lender controlled by electric cooperatives and credit unions with aggregate uncollateralized outward exposure plus potential outward swap exposure less than $1 billion.

Section 1a(49)(A)(iv) of the Dodd-Frank Act provides that in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer. It is common for banks, for example, to lend at variable rates to commercial customers, and in connection with that loan, provide an interest rate swap so that the customer is able to achieve a fixed rate on the loan. The swaps in connection with loans' exemption included in the swap dealer definition was intended to permit banks to continue providing this service to their customers without being designated as swap dealers. Congress recognized that the efficiency created by pairing these transactions facilitates the flow of credit.

H.R. 3336 extends the exemption to farm credit institutions that provide similar services to their customers but that do not fall within the definition of insured depository institution. In addition, the bill clarifies that the exemption is to be applied when the institutions enter into swaps in connection with an extension of credit, and that it is not limited to a swap that is provided exactly at the point of origination and only when the credit extended to the customer is a loan. This clarification is intended to accommodate common transactions between small and mid-size banks and farm credit institutions and their customers whereby the swap may be provided before or after the credit is originated, and when the credit may be in the form of a guarantee, or letter of credit, for example, rather than just a traditional loan.

In the CFTC's proposed rule `End-User Exception to Mandatory Clearing of Swaps,' the CFTC did not propose to provide an exemption as authorized by Congress. In order to ensure that small financial institutions are afforded the relief that Congress intended, H.R. 3336 requires the CFTC to exempt small financial institutions that have exposure that is less than $1 billion in current uncollateralized exposure plus potential future exposure. Collectively, small banks engage in only a fraction of the swaps activity in the U.S. banking system. In fact, 25 of the largest bank holding companies hold 99.86% of the total notional held by all banks in the U.S., leaving only .14% of the total notional spread across the remaining 1,046 banks. House Committee Report No. 112-390.

The legislation is necessary to ensure that small and mid-size financial institutions can continue to provide important hedging tools to small businesses, and that the banks themselves can continue to use swaps to hedge their own interest rate risk. The bill acknowledges and upholds the important relationship between risk management tools and the flow of credit in the economy. At the same time, there are important safeguards in place to prevent any small financial institution from engaging in speculative or highly risky activity, or to engaging in swaps to a level that their positions could pose a threat to the financial system. House Committee Report No. 112-390.