A New Threat to Financial Reform
Passing a last-minute spending bill to avoid shutting down the U.S. government might be better than another self-inflicted budget crisis, but the deal on the table is nothing to be proud of. The measure approved by the House of Representatives last night and now before the Senate carries with it a set of so-called riders, which change policy in ways that haven't been examined or discussed. One of them is especially troublesome. It weakens the Dodd-Frank financial reforms.
The rider in question removes the so-called swaps push-out rule, which was intended to reduce the risks posed by the largest U.S. banks' trading in derivatives. Without it, regulators will have to work harder in other areas to promote stability.
The rule addressed a dangerous incentive created by the pre-crash regulatory system. Various government backstops, such as deposit insurance and access to emergency loans from the Federal Reserve, have given the largest banks a great advantage in the derivatives market: Counterparties assume that the government will help them make good on their obligations. This implicit subsidy encouraged them to build huge, interconnected trading operations. Trouble at any one of them could trigger a broader panic and necessitate a rescue.
The size of the business is staggering. As of June, the top four banks -- JPMorgan Chase, Citigroup, Goldman Sachs and Bank of America -- had written derivative contracts on the equivalent of more than $200 trillion in stocks, bonds and other assets.
The rule told banks to move some of their derivatives out of federally insured, deposit-taking subsidiaries and to put them in other units instead. This was never going to make the financial system safe on its own. In the case of the biggest banks, all units, not just deposit-takers, enjoy government support, as the bailouts of 2008 and 2009 plainly demonstrated. In addition, pleading practical difficulties, banks had already succeeded in narrowing the scope of the requirement.
Still, the swaps rule would have been helpful. Its demise gives regulators more work to do. They'll probably need to take further steps to reduce the value of the government subsidy, by making banks less likely to need it.
How? First, by making sure that banks have ample capital, and plenty of cash on hand, to cope with sudden setbacks. Here, the regulators have made a start but need to do more. Second, by requiring derivatives trades to be routed transparently through new central counterparties and by setting up trading hubs that let investors transact directly with one another. This strengthening of the financial infrastructure is in train. Third, by monitoring the market for dangerous concentrations of risk, such as the credit-derivative positions that almost brought down insurance giant AIG and a number of large banks in 2008. Here, progress has been sluggish at best.
The killing of the swaps rule needn't be a disaster. That's what it would be, though, if it proved to be the first step in a broader rollback of financial reform, and if regulators failed to use their other powers to better effect.
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