Two congressional committees in charge of drafting legislation to regulate derivatives have quietly killed a provision that would allow the Federal Reserve to police the complicated financial transactions. The kind of derivatives that many blame for the near-collapse of the American financial system have never been regulated.
In July, the Obama administration sent a proposed bill to Congress requesting that the Federal Reserve be given authority to oversee those aspects of the financial system that posed "systemic risk" -- in short the kind of firms and activities that could bring down the entire financial system. It would be up to the Fed and other federal regulators to determine what constituted "systemic risk." The trading of derivatives, essentially contracts that can act as insurance against a future event or as just a simple bet, were part of the package.
Derivatives brought down the Wall Street investment banks Lehman Brothers and Bear Stearns and nearly caused insurance giant AIG to go belly up. The reason why they nearly brought down the entire financial system is because every major financial firm and bank were tied to them through derivatives deals. They were all interconnected. But there wasn't a single regulator looking at that. Rather, individual government regulators -- both state and federal -- were overseeing their own individual part of the pie, instead of the whole thing. Obama's plan is an attempt to change that.
But late Friday afternoon, the House Agriculture Committee quietly posted to its Web site a revised version of the Obama administration-proposed legislation. The Committee, which has jurisdiction over one of the two federal regulators of derivatives trading -- the Commodity Futures Trading Commission (CFTC) -- deleted the portion of Obama's bill that gives the Federal Reserve a say in those derivatives activities that pose a risk to the financial system. Specifically, the Fed would have been given the power to oversee new rules set up by the exchanges and clearinghouses where derivatives trading takes place. The previous version of the Agriculture committee's bill, released Oct. 9, included that passage. The current bill places that power solely in the hands of the CFTC.
A spokesman for House Agriculture Committee Chairman Rep. Collin Peterson, a Democrat from Minnesota, could not be reached for comment late Friday.
The move follows that of the House Financial Services Committee, where Rep. Judy Biggert, an Illinois Republican, offered an amendment striking the same provision in their version of the bill with the agreement of Committee Chairman Rep. Barney Frank (D-Mass.). The original version of the Financial Services bill, though, was a bit stronger than the Agriculture bill (at least in this aspect) because it included all of the language originally put forward by the administration regarding systemic risk. Specifically, the administration's proposal gave the Fed authority over not only new rules governing derivatives trading that threatened the system, but also over new derivatives and how the trading of them would be processed.
Frank allowed Biggert's amendment to pass without debate, punting the issue to the Agriculture committee. His spokesman says the Financial Services Committee lacks jurisdiction in this area, thus calling the committee's move "irrelevant." However, Frank and the rest of the committee did impose additional regulation on other aspects of derivatives trading that fall under Agriculture's jurisdiction.
In its white paper announcing its detailed plans to overhaul financial regulation, the administration explained how derivatives led to the economy's near-collapse, and why the Federal Reserve would need additional power over them:
"Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce systemic risk, to promote efficiency, and to contribute to a better allocation of resources," the administration said.
"However, instead of appropriately distributing risks, this process often concentrated risk in opaque and complex ways. Innovations occurred too rapidly...for the nation's financial supervisors.
"The build-up of risk in the over-the-counter (OTC) derivatives markets, which were thought to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the crisis," the administration said. "We propose to enhance the Federal Reserve's authority over market infrastructure to reduce the potential for contagion among financial firms and markets."
Derivatives, the administration said in its draft legislation, "may also concentrate and create new risks and thus must be well designed and operated in a safe and sound manner. Enhancements to the regulation and supervision of systemically important financial market utilities and the conduct of systemically important...activities by financial institutions are necessary to provide consistency, to promote robust risk management and safety and soundness, to reduce systemic risks, and to support the stability of the broader financial system."
Thus, "responsibility and authority for ensuring consistent oversight of all systemically important...activities should be assigned to the Federal Reserve," the administration said.
Officials from the Federal Reserve also have lobbied for the added role, arguing that it's best suited to minimize destabilizing threats to the financial system.
"The [Federal Reserve] Board believes that all systemically critical firms should have a consolidated supervisor, as well as be subject to the oversight of any systemic regulator that might be created," said Patricia White, associate director of the Fed's division of research and statistics, in June during testimony before the U.S. Senate. "The scope of a firm's activities in the OTC derivatives market will likely be an important factor in making that assessment."
Fed Chairman Ben Bernanke echoed those remarks the next month during testimony before Barney Frank's Financial Services Committee.
"It is critical that systemically important systems and activities be subject to strong and consistent prudential standards designed to ensure the identification and sound management of credit, liquidity, and operational risks," Bernanke said. "The Federal Reserve also would expect to carefully monitor and address, either individually or in conjunction with other supervisors and regulators, the potential for additional spillover effects...For example, the failure of one firm may lead to deposit or liability runs at other firms that are seen by investors as similarly situated or that have exposures to such firms. In the recent financial crisis, exactly this sort of spillover resulted from the failure of Lehman Brothers, which led to heightened pressures on other investment banks."
Thus, in explaining why the Fed would need additional police power over things like derivatives trading, Bernanke brought up the failure of Lehman Brothers, the largest bankruptcy filing in U.S. history. At the time of its demise, the storied Wall Street investment bank listed more than $613 billion in debt.
But as it stands, the Fed won't be getting that power from the two derivatives bills currently snaking through congressional committees. Rather, it will be fragmented across an array of federal and private regulators -- just what the Obama administration warned against.
The Treasury Department declined to comment.