Why Wall Street Fears Derivatives Regulation

A two-page provision tucked inside the 1,500-plus-page financial reform bill being debated in the Senate has Wall Street worried. The provision would change the structure of about 40 of the largest U.S. banks by forcing them to spin off their derivatives businesses, which provide billions of dollars in profits annually.

While derivatives such as credit default swaps have become infamous for their role in the banking crisis, currency and interest-rate swaps represent a much bigger share of the business. U.S. commercial banks generated a record $22.6 billion in derivatives trading revenues in 2009, with $14.5 billion of that coming from interest-rate contracts, according to a survey of 1,030 federally insured banks by the Office of the Comptroller of the Currency.

Senator Blanche Lincoln (D—Ark.) added the provision to the reform bill, which already included restrictions on derivatives. "This bill has moved so far left, so hard, that it's caught everybody by surprise," says Paul Miller, a bank analyst for FBR Capital Markets (FBCM). Some analysts suggest that banks might be able to hang on to derivatives units by turning them into separately capitalized subsidiaries. But Lincoln, speaking on the Senate floor on May 5, emphasized that banks should not be in the derivatives business. "In my view," she said, "banks were never intended to perform these activities."

Other elements of the bill would require that standard derivatives contracts be traded on exchanges, and that derivatives traders use clearinghouses, which guarantee contracts between two companies, for most transactions. The effect of those two measures would be to increase disclosure, raise capital requirements, and lower profit margins for what has been an extremely lucrative industry.

Lincoln's initiative has been denounced by FDIC Chairman Sheila Bair, Federal Reserve staff and, indirectly, by Treasury Secretary Timothy Geithner, who said last week that "you would not make the system more stable by taking functions that are integral and central to banking and separating and putting them somewhere else."

At this point it's not clear whether the Lincoln provision will survive. The floor debate on the financial overhaul bill opened with other contentious issues last week. While senators debated "too-big-to-fail" and the fate of a consumer protection agency, members of both parties discussed how to soften or kill the "spin-off" provision. Most observers expect the language to be pared down. But with the public focused on Wall Street excess, no senator has come forward to wield the knife.

The bottom line: With the public in an anti-Wall Street mood, Congress may do far more to rein in derivatives than anyone thought.

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