More than half of the derivatives- trading business of Goldman Sachs Group Inc. (GS), Morgan Stanley and three other large banks could fall largely outside the Dodd- Frank Act if they succeed in lobbying regulators to exempt their overseas operations, government records show.
The debate over the reach of Dodd-Frank has been among the most contentious aspects of the regulatory overhaul enacted by President Barack Obama after the 2008 credit crisis. The banks have met with regulators, testified to Congress and filed dozens of letters contending that they will suffer a competitive disadvantage if the regulations apply to their foreign arms.
Banking lobbyists have been gaining traction with their argument that a combination of U.S. supervision of their holding companies and foreign supervision of their operations abroad is sufficient to oversee risk to the financial system.
While the banks haven’t publicized how much of their swaps business is overseas, they file quarterly statements to the Federal Reserve. A Bloomberg News analysis of the filings shows that Goldman Sachs had 62 percent of its $134 billion in fair- value derivatives assets and liabilities in non-U.S. branches or subsidiaries for international banking as of Sept. 30, while 77 percent of Morgan Stanley (MS)’s $101 billion was in non-U.S. operations.
If overseas operations aren’t subject to U.S. rules or equivalent regulation by other nations, it could impede the goal of preventing another credit crisis, Darrell Duffie, professor at Stanford University’s Graduate School of Business, said in a telephone interview.
“Not only is that neglectful from a viewpoint of systemic risk as it sits today, but it’s also an incitement to move the risk abroad,” Duffie said.
JPMorgan and Citigroup
The Fed filings show that JPMorgan Chase & Co. had 59 percent of its $188 billion in overseas branches or international affiliates; Citigroup Inc. (C) had 53 percent of $122 billion; and Bank of America Corp. had half of $125 billion in non-U.S. operations in the same period.
The fair-value assets and liabilities include the value of interest rate, foreign exchange, commodity, equity and credit derivatives that are held for trading purposes and marked at market prices.
JPMorgan uses a different method to determine the size of its derivatives business, according to a person familiar with the bank’s operations. As a consolidated bank, JPMorgan calculates that it has $30 billion in derivatives exposure once assets and liabilities are netted. The exposure includes 53 percent, or $16 billion, in foreign branches and subsidiaries, and 47 percent, or $14 billion, in domestic offices, said the person, who spoke on condition of anonymity because the bank has not authorized employees to speak publicly on the matter.
Spokesmen Michael S. Duvally of Goldman Sachs, Mary Claire Delaney of Morgan Stanley, Molly Millerwise Meiners of Citigroup and Jerry Dubrowski of Bank of America declined to comment. Joe Pavel, a spokesman for the Federal Reserve, declined to comment on the reach of Dodd-Frank.
The banks have been focused on rules that the Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency proposed in April, requiring capital and margin to be set aside to reduce risk in non-cleared trades.
Dodd-Frank aims to have most derivatives guaranteed by clearinghouses that stand between buyers and sellers and traded on public exchanges or other venues. The law requires regulators to set capital and margin for trades that remain non-cleared, or transacted directly between buyers and sellers. Non-cleared trades can be more profitable for dealers.
‘No Lesser Risk’
The regulators said in their April proposal that foreign swaps pose “no lesser risk” to a U.S. company because of their location and noted that an exemption might allow banks to design swaps to evade the law by using their overseas affiliates. While global regulators are looking to establish an international regulatory system for margin to level the playing field, they have yet to announce a plan.
The tension about the scope of the rules has its roots in a part of Dodd-Frank known among lawyers and regulators as 722d, for its section number in the law. Under the provision, the Commodity Futures Trading Commission, which has authority to regulate most of the U.S. swaps market, may apply its rules to transactions with a “direct and significant connection with activities in, or effect on, commerce of the United States.”
Dodd-Frank “expresses clear congressional intent that it apply to certain extraterritorial activities,” Dan Berkovitz, the CFTC’s general counsel, said last year at a day-long agency meeting with banks, energy companies and exchanges.
The provision raised the stakes for banks because their swaps business is global. In 2008, Sally Davies, a Fed adviser, said that between 55 percent and 75 percent of U.S. banks’ notional derivatives exposure was with non-U.S. residents.
For example, New York-based Goldman Sachs’s largest counterparty for credit derivatives on the eve of the credit crisis in June 2008 was Deutsche Bank AG (DB)’s London branch; its third-largest interest-rate derivatives counterparty was JPMorgan’s London branch; and its largest counterparty for currency products was Royal Bank of Scotland Plc’s London branch, according to a 2010 report from the Financial Crisis Inquiry Commission, a U.S. panel that investigated the crisis.
Selling over-the-counter derivatives is among the most lucrative business for financial companies, with U.S. bank holding companies reporting $14 billion in trading revenue in the third quarter of 2011, according to the OCC. The five banks control 95 percent of cash and derivatives trading for U.S. bank holding companies, which had $326 trillion in notional derivatives as of Sept. 30, the agency said.
Allies in Congress
In seeking the foreign exemption, the five banks have enlisted H. Rodgin Cohen and Kenneth M. Raisler, among other lawyers at New York-based Sullivan & Cromwell LLP. Edward J. Rosen, a New York-based partner at Cleary Gottlieb Steen & Hamilton LLP, has taken a similar position as representative of a dozen U.S. and international banks, including UBS Securities LLC and Barclays Capital.
The lobbying has found allies in Congress and among regulators as agencies prepare to complete their rules before 2013. Senator Tim Johnson, a South Dakota Democrat and chairman of the Senate Banking Committee, and Representative Barney Frank, a Massachusetts Democrat and namesake of the law, are among lawmakers from both parties urging regulators to focus their rules primarily on the banks’ U.S. businesses.
“If those margin rules for foreign operations are maintained and Europeans and other foreign jurisdictions do not match it, that would be a significant competitive disadvantage,” Fed Chairman Ben S. Bernanke testified to Congress on July 21. John Walsh, acting Comptroller of the Currency, said on Jan. 26 that regulators understand the industry’s concerns and will be “carefully considering all of the issues” raised.
Derivatives, including swaps, are financial contracts tied to interest rates, commodities or events, such as the default of a company. The values of overseas derivatives held by individual banks that were calculated for this story include assets and liabilities for foreign branches and subsidiaries, including so- called Edge corporations.
Edge corporations, formed under the 1919 Edge Act on international banking, are bank subsidiaries for which Congress granted greater leeway to compete overseas. Citibank Overseas Investment Corp., J.P.Morgan International Finance Limited and Bankamerica International Financial Corp. are among Edge subsidiaries that have interest rate and equity derivatives and could benefit from an exemption.
The banks don’t report the holdings of Edge corporations in their standard quarterly filings. According to documents obtained through a public records request to the Fed, Citibank’s Edge corporation had a combined $7.8 billion in fair-value derivatives as trading assets and liabilities in the first quarter of 2011, while JPMorgan’s had $88 billion.
Banks are seeking to have Edge corporations and other international affiliates exempted from Dodd-Frank rules when they have contracts with non-U.S. companies, Sullivan & Cromwell said in a letter on June 29. The exemption should also cover the subsidiaries’ swaps with foreign-based affiliates of other U.S. companies because the trades don’t have a direct and significant effect on U.S. commerce, the law firm said in its letter. Under the requested exemption, two U.S. companies could trade swaps outside of Dodd-Frank rules so long as their overseas affiliates engaged in the transaction.
The combination of U.S. banking supervision at the parent company level and foreign regulation of overseas operations is sufficient to protect the U.S. financial system, according to the Sullivan & Cromwell lawyers.
Preventing an AIG
U.S. and European Union regulators have said they want to bridge international gaps to avoid disparities that helped undermine oversight of American International Group Inc. (AIG) in 2007 and 2008 and contributed to a $180 billion taxpayer bailout. The insurer booked many of its swaps in Europe, where regulators in 2007 decided that U.S. authorities should have oversight. That transatlantic split “excluded any comprehensive examination and regulation” of AIG’s credit-default swaps, the U.S. Congressional Oversight Panel said in a June 2010 report.
Still, gaps have emerged since the heads of the G-20 countries, a group consisting of the world’s richest nations, met in Pittsburgh in 2009 to plan financial regulatory changes.
For example, the CFTC approved new limits on speculation in oil, natural gas and other commodities, while British regulators oppose hard government-set caps. The U.S. also aims to prohibit a single dealer from owning and running a swaps-trading venue. Other G-20 countries say multi-dealer platforms aren’t essential to the market overhaul, the Financial Stability Board, an international panel set up to monitor the implementation of derivatives rules globally, said in an Oct. 11 report.
Waiting for SEC
CFTC Chairman Gary Gensler said this month that his agency won’t complete guidelines on the reach of Dodd-Frank until after April, while the financial industry waits for a similar proposal from the Securities and Exchange Commission. Gensler has said the CFTC may eventually defer to foreign regulators when they have comparable and consistent regulations.
“This is the obvious place for harmonization -- for regulators to get together across jurisdictions to work this out, because otherwise you end up trampling on each other’s feet and possibly going at cross purposes,” Duffie said.
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