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FDIC Head Sheila Bair: Let Banks Keep Derivatives

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WASHINGTON — A top government banking regulator wants Senate Democrats to let banks keep most of their business in complex – and profitable – securities known as derivatives.

A sweeping overhaul of banking regulations pending in the Senate would require banks to spin off their derivatives business.

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corp., said that provision could shift the creation of derivatives contracts outside the reach of regulators.

"If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less regulated and more highly leveraged venues," Bair wrote in a letter to Senate Banking Committee chairman Christopher Dodd, D-Conn., and Agriculture Committee Chairwoman Blanche Lincoln, D-Ark.

A copy of the letter was obtained by the Associated Press.

The derivatives measure, pushed by Lincoln, would require banks to set up separate subsidiaries, with their own source of capital, to run what has been a highly profitable derivatives business. Derivatives are the exotic speculative and risk-hedging instruments blamed for helping plunge Wall Street into a near meltdown in 2008.

The Obama administration has also indicated it does not support the provision. The FDIC is at least the second bank overseer to oppose the ban. Federal Reserve officials, in a letter to senators, also have called on the Senate to remove the spin-off requirement.

Dodd agreed to keep that restriction after negotiating with Lincoln last weekend. The decision stunned the bank industry, which immediately mobilized to get it removed.

But even if that provision is ultimately removed, there is bipartisan support for restricting banks from trading in derivatives with their own accounts for purely speculative purposes.

Indeed, in her three-page letter, Bair said that neither banks nor bank holding companies should engage in speculative derivatives trading. But she said banks have a legitimate need of derivatives to help them hedge against interest rate fluctuations.

Moreover, she said, banks "play an essential role" creating markets for commercial firms that enter into derivatives contracts to manage their risks.

The value of derivatives depends on the price of some underlying asset. Corn futures and stock options are examples of some of the simpler derivative products.

Bair said that even if banks created subsidiaries for their derivatives business, those entities would be outside the FDIC's scrutiny. "We do not have the same comprehensive backup authority over the affiliates of banks as we do with the banks themselves," she wrote.

Representatives from Dodd's and Lincoln's offices were not immediately available to comment.

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