Yesterday, in a letter to Chris Dodd, the chairman of the Senate Banking Committee, Federal Reserve chief Ben Bernanke reiterated his opposition to a measure that may be the financial reform proposal most feared among the large banks.
The provison put forth by Sen. Blanche Lincoln (D - Ark.) would require that banks spin off large portions of their derivatives trading operations. Five banks dominate the derivatives market, holding "97 percent of the total $212.8 trillion worth of derivatives contracts held by U.S. commercial banks," Reuters notes.
In a recent blog post, Robert Reich, the former Secretary of Labor, called Lincoln's provision "the biggest battle in bank reform." Derivatives, of course, have been widely criticized for fueling the financial crisis and escaping regulation.
In his letter, Bernanke echoed recent comments from FDIC chairwoman Sheila Bair, who also opposes Lincoln's proposal. Bernanke wrote:
"Prohibiting depository institutions from engaging in significant swaps activities will weaken the risk mitigation efforts of banks and their customers. Depository institutions use derivatives to help mitigate the risks of their normal banking activities."
Bernanke also took aim at a section of the proposal that would prevent commercial banks with swaps desks from borrowing from at ultra-low rates from the Federal Reserve. Here's more from Bernanke:
"Experience over the past two years demonstrates that such broad-based facilities can play a critical role in stemming financial panics and addressing severe strains in the financial markets that threaten financial stability, the flow of credit to households and businesses, and economic growth."
The proposal would make the "financial system less resilient and more susceptible to systemic risk," Bernanke wrote.
READ Bernanke's letter:
The Honorable Christopher J. Dodd
Committee on Banking, Housing,
and Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
You have asked for my views on section 716 of S. 3217. This section would prevent many insured depository institutions from engaging in swaps-related activities to hedge their own financial risks or to meet the hedging needs of their customers, and would prohibit nonbank swaps entities, including swap dealers, clearing agencies and derivative clearing organizations, from receiving any type of Federal assistance.
The Federal Reserve has been a strong proponent of changes to strengthen the regulatory framework and infrastructure for over-the-counter (OTC) derivative markets to reduce systemic risks, promote transparency, and enhance the safety and soundness of banking organizations and other financial institutions. Title VII and Title VIII of S. 3217 include important provisions designed to achieve these goals. For example, Title VII would require most derivative contracts to be cleared through central clearinghouses and traded on exchanges or open trading facilities, require information concerning all other derivatives contracts to be reported to trade repositories or regulators, and provide the regulatory agencies significant new authorities to ensure that all swaps dealers and major swap participants are subject to strong capital, margin, and collateral requirements with respect to their swap activities. Title VIII also includes provisions designed to help ensure that centralized market utilities for clearing and settling payments, securities, and derivatives transactions (financial market utilities), which are critical choke points in the financial system, are subject to robust and consistent risk management standards-including collateral, margin, and robust private-sector liquidity arrangements--and do not pose a systemic risk to the financial system. I have also frequently made clear that we must end the notion that some firms are "too-big-to-fail." For that reason, the Federal Reserve has advocated the development of enhanced and rigorous prudential standards for all large, interconnected financial firms, and the enactment of a new resolution regime that would allow systemically important financial firms to be resolved in an orderly manner, with losses imposed on the Federal Reserve to provide emergency, secured credit to nondepository institutions only through broad-based liquidity facilities designed to address serious strains in the financial markets, and not to bailout any specific firm.
S. 3217 makes important contributions to the goals of reducing systemic risk, eliminating the too-big-to-fail problem, and strengthening prudential supervision. I am concerned, however, that section 716 is counter-productive to achieving these goals. In particular, section 716 would essentially prohibit all insured depository institutions from acting as a swap dealer or a major swap participant--even when the institution acts in these capacities to serve the commercial and hedging needs of its customers or to hedge the institution's own financial risks. Forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities.
Prohibiting depository institutions from engaging in significant swaps activities will weaken the risk mitigation efforts of banks and their customers. Depository institutions use derivatives to help mitigate the risks of their normal banking activities.
For example, depository institutions use derivatives to hedge the interest rate, currency, and credit risks that arise from their loan, securities, and deposit portfolios. Use of derivatives by depository institutions to mitigate risks in the banking business also provides important protection to the deposit insurance fund and taxpayers as well as to the financial system more broadly. In addition, banks acquire substantial expertise in assessing and managing interest rate, currency, and credit risk in their ordinary commercial banking business. Thus, banks are well situated to be efficient and prudent providers of these risk management tools to customers.
Importantly, banks conduct their derivatives activities in an environment that is subject to strong prudential Federal supervision and regulation, including capital regulations that specifically take account of a bank's exposures to derivative transactions.
The Basel Committee on Banking Supervision has recently proposed tough new capital and liquidity requirements for derivatives that will further strengthen the prudential standards that apply to bank derivative activities. Titles I, III, VI, VII and VIII of S.3217 all add provisions further strengthening the authority of the Federal banking agencies and other supervisory agencies to address the risks of derivatives. Section 716 would force derivatives activities out of banks and potentially into less regulated entities or into foreign firms that operate outside the boundaries of our Federal regulatory system. The movement of derivatives to entities outside the reach of the Federal supervisory agencies would increase, rather than reduce the risk to the financial system. In addition, foreign jurisdictions are highly unlikely to push derivatives business out of their banks ..
Accordingly, foreign banks will have a competitive advantage over U.S. banking firms in
the global derivatives marketplace, and derivatives transactions could migrate outside the United States.
More broadly, section 716 would prohibit the Federal Reserve from lending to any swaps dealer or major swap participant--regardless of whether it is affiliated with a bank--even under a broad-based 13(3) liquidity facility in a financial crisis. Experience over the past two years demonstrates that such broad-based facilities can play a critical role in stemming financial panics and addressing severe strains in the financial markets that threaten financial stability, the flow of credit to households and businesses, and economic growth. These facilities will be less effective if participants must choose between continuing (or unwinding) derivatives positions and participating in the market liquefying facility.
I am concerned that section 716 in its present form would make the U.S. financial system less resilient and more susceptible to systemic risk and, thus, is inconsistent with the important goals of financial reform legislation. We look forward to continuing to work with the Congress as you work to enact strong regulatory reform legislation that both addresses the weaknesses in the financial regulatory system that became painfully evident during the crisis, and positions the regulatory system to meet the inevitable challenges that lie ahead in the 215t century.