07/10/2010 05:12 am ET | Updated May 25, 2011

Banks Must Be Barred from Dealing Derivatives: It's NOT a Normal Part of the Business of Banking

Jane D'Arista and Gerald Epstein
Political Economy Research Institute (PERI), University of Massachusetts, Amherst
and Coordinators of SAFER

The furor over the inclusion of Senate Agriculture Chairwoman Blanche Lincoln's amendment in the Senate bill is becoming somewhat ludicrous. Good, knowledgeable people such as FDIC Chairman Sheila Bair and former Federal Reserve Chairman Paul Volcker have stepped up - no doubt at the Fed's and Treasury's bidding - to strew misinformation in the path of what, to date, is the most powerful structural change in the bill in terms of both mitigating risk and preventing future bailouts. The controversial part of the amendment - section 716 - would ban Federal Reserve assistance through a credit facility or the discount window or loan or debt guarantees by the FDIC to any dealer in swap contracts. This would mean that banks that are insured by the FDIC - including the large banks that now dominate the market - would have to spin off their derivatives desks. Like the Volcker rule itself, the intent is to remove risky activities from the core banking functions that are essential to the economy and to ensure that those risky activities will not trigger the need for a bail out to prevent systemic collapse in the future as they did in the 2008 crisis.

Chairman Bair's concern was that forcing derivatives dealers out of banks would move the business into less regulated and more leveraged entities. While saying that banks should not engage in speculative activities, she argued that banks have an important role in creating markets for their customers while needing to hedge interest rate risks related to their core lending business. Chairman Volcker, too, took the position that providing derivatives is a normal part of a banking relationship with a customer and should not be prohibited.

These are assertions that need to be questioned. First, if banks' role in selling derivatives is so important and if it is part of the usual course of a banking relationship, why is it that only five banks - J.P. Morgan Chase, Citibank, Bank of America, Goldman Sachs and Morgan Stanley - account for 90 percent of the market? Surely that kind of oligopolistic domination of the market makes clear that it is not an activity normally undertaken by banks. Moreover, the level of concentration among swaps dealers is, in itself, systemically risky in addition to being anti-competitive.

Second, separating swap dealing operations from the business of banking does not mean that banks will be unable to hedge their banking risks. They will become end users with an interest in seeing that the dealers from whom they buy derivatives are well managed, well regulated and well capitalized. In addition, the largest dealers will be able to retain what, for them has been a major profit center by moving their swaps desks into subsidiaries under the bank's holding company. Their only loss will be the inability to sell and trade without disclosing the prices they charge since most of their business will be conducted through clearing houses and exchanges and subject to requirements for disclosure and reporting that off-balance sheet, over-the-counter markets are designed to evade.

But, third, and perhaps most important, the assumption that taking derivatives desks out of banks will make the business less regulated and more leveraged is simply wrong. For one thing, the requirements for prudential oversight under Title VII of the bill will apply standards for capital adequacy, transparency, anti-fraud and anti-manipulation to stand-alone derivatives dealers. But the equally important point is that they couldn't possibly be less regulated and less well capitalized than the bank dealers are now.

Chairman Lincoln's provisions have the enormous value of getting the vast dealing and trading operations in derivatives out of the shadowy off-balance sheet world where they are now posted by the large bank and investment bank dealers. This will have very substantial systemic benefits for the derivatives market and for the banking system as well. Moving the selling and trading of these instruments into separate entities will increase transparency by bringing derivatives out of the shadows so that dealers can be more easily regulated and the prices and volume of purchases and sales in the market will be readily available to counterparties. It will also ensure a better capitalized derivatives market since, as the crisis revealed, there is so little capital backing for the off-balance sheet liabilities of the large banks where the majority of the business is still being conducted. In addition, it will shrink the enormous exposure of a few very large banks that can threaten the stability of other financial institutions and the many non-financial companies that use this market.

Chairman Lincoln's amendment is sensible and prophylactic. It goes to the heart of the interconnectedness problem that has been exacerbated by oligopolistic market domination. Requiring a stand-alone structure for dealers will tend to encourage new entrants and bring the benefits of competition to end users in all sectors of the economy. If, as critics of the amendment argue, derivatives have become such a critical part of the financial system in the few decades since their invention, it is time they emerged from underground to be bought and sold in an open market. To permit the ongoing domination of an opaque market by so few banks ensures that the subsidies and bailouts needed to keep these firms viable will also be ongoing. A vote against the Lincoln amendment is a vote to perpetuate Too Big to Fail.