07/07/2010 05:12 am ET | Updated May 25, 2011

Former Fed Chairman Volcker Opposes Forcing Banks To Spin Off Swaps Desks

The establishment is lining up against Blanche Lincoln.

As chairman of the Senate Agriculture Committee, the Arkansas senator authored a bipartisan bill to reform the derivatives market. Its centerpiece is a provision banning banks from also acting as derivatives dealers. Banking Committee Chairman Christopher Dodd (D-Conn.) incorporated Lincoln's bill into the pending financial reform legislation.

Because banks enjoy explicit taxpayer support through federal deposit insurance and access to cheap funds via the Federal Reserve's discount lending window, Lincoln doesn't want taxpayers to implicitly support derivatives dealing. Derivatives, traditionally used as a risk-management tool, amplified and exacerbated the financial crisis because their use was abused by firms that simply used them to place bets. This bound financial firms together in ways that weren't fully understood until the height of the crisis, necessitating further taxpayer support.

But her proposal, widely supported by reformers, has met fierce opposition from Wall Street, its supporters in the Senate and the Obama administration, including pro-reform voices like Paul Volcker and Sheila Bair.

Wall Street argues that it's too costly -- forcing banks to spin off their derivatives desks into non-taxpayer supported affiliates compels firms to raise additional cash to support them.

Bank regulators such as Federal Deposit Insurance Corporation Chairman Sheila Bair and Obama administration officials such as Timothy Geithner argue that it's safer to keep swaps desks inside banks because bank regulation is tougher than the regulatory regime over nonbanks. Better to keep these units inside better-regulated institutions, they argue.

Lincoln counters with an argument that resonates among reformers: let banks be banks. Dealing in derivatives and other complex securities should be left to investment firms and other specialists that don't enjoy taxpayer protection. In short, taxpayers shouldn't backstop speculation.

But now, former Federal Reserve Chairman Paul Volcker has thrown his weight behind those trying to kill Lincoln's proposal.

"The provision of derivatives by commercial banks to their customers in the usual course of a banking relationship should not be prohibited," Volcker wrote in a letter dated Thursday to Dodd, Geithner, and Sens. Shelby (R-Ala.), Merkley (D-Ore.), Levin (D-Mich.) and Lincoln.

Volcker wrote that other parts of Dodd's bill, plus an amendment by Merkley and Levin that attempts to rein in banks' trading activities, sufficiently address his concerns about taxpayer-supported banks leveraging that support to speculate in the markets.

His letter comes on the heels of comments made by Geithner during a Thursday appearance before the Financial Crisis Inquiry Commission.

"When people look back at this crisis, when they look at the excessive risks taken by large financial institutions, the natural inclination is to move those risky activities elsewhere. To create stability, some argue, we should just separate banks from 'risk.'

"But, in important ways, that is exactly what caused this crisis.

"The lesson of this crisis, and of the parallel financial system, is that we cannot make the economy safe by taking functions central to the business of banking, functions necessary to help raise capital for businesses and help businesses hedge risk, and move them outside banks, and outside the reach of strong regulation," Geithner said in his prepared remarks.

It's unclear how the issuance of anything beyond basic derivatives contracts that seek to minimize risk to fluctuations in interest rates, currency exchange rates, and commodity prices is "central to the business of banking."

READ Volcker's letter below: