There’s been quite a lot of drama this week surrounding Blanche Lincoln’s swaps desk spin-off, known as “Section 716.” Ultimately, I don’t think it will amount to anything — Lincoln doesn’t have the support of a majority of either the House or Senate Dems on the conference committee (certainly not the Senate Dems), so yeah, I still think it will be stripped out. The fact that Lincoln is floating compromises just shows that she's the one who needs a deal.

Nevertheless, there’s a ton of misinformation out there about Section 716, as well as the compromises Lincoln floated on Monday, so I want to clear some things up. Here are the compromises Lincoln is offering:


New FED Section 13 (3) Broad Based Federal Assistance to Swap Entities would be ok

Swap Dealer can be a BHC Affiliate
• Separately capitalized
• Subject to 23A and 23B restrictions

Bank MSPs not subject to FDIC Insurance and Fed Discount window restrictions.

FDIC bridge banks, conservatorships and receiverships exempted

2 Year Transition Period to “Push Out”

FBA gets to determine time frame for push out

FBA consults with SEC/CFTC

FBA required to consider impact on:
-Mortgage lending
-Small business Lending
-Capital Formation

It’s important to note that these are substantive changes. They are not mere “clarifications,” as Lincoln’s staff and her supporters claim. Lincoln’s original proposal would not have allowed banks to spin off their swaps desks into “separately capitalized affiliates” within the bank holding company (BHC), nor would it have allowed banks to use swaps to hedge their own portfolios. I know that Lincoln’s staff has been claiming for a while that Section 716 would only force spin-offs into separately capitalized affiliates, and that banks would still be allowed to use swaps to hedge their own portfolios, but that’s just not true. Remember, Lincoln only started making this claim after she released her proposal and it started getting slammed as outrageous (which it is). She essentially backtracked, and claimed that she wasn’t actually that crazy, it’s just that people had misunderstood what she was saying. (In fact, she's backtracked so much that now she's saying, “These institutions are gonna continue to deal in swaps, and we all know that that's necessary.” Really, Blanche? Clearly you didn't know that a couple months ago when you introduced your proposal.)

In any event, Lincoln’s interpretation of her proposal isn’t even remotely supported by the language of Section 716, which clearly prohibits “major swap participants” (i.e., commercial banks, who are naturally the biggest users of swaps) from using the Fed’s discount window or receiving FDIC insurance. That’s why her compromise states that “Bank MSPs [are] not subject to FDIC Insurance and Fed Discount window restrictions.” That’s not a “clarification,” that’s a major, substantive change. There’s also nothing in Section 716 about BHC affiliates, nothing about them being “separately capitalized,” and certainly nothing about them having to hold more capital than is currently required. People who have been claiming that Lincoln’s proposal is just about making sure banks have more capital to back their swaps desks have been simply making things up. (It's disappointing that in this debate, the progressives are the ones who have been spreading blatant misinformation; the fact that they're trying to take the high road makes it even worse.)

Look, if this was just about moving swaps desks into separate affiliates within the BHC, this wouldn’t be that big of a fight. (It would still be a fight, because it would still be a stupid idea and horrible policy, but it wouldn’t be nearly as important.) But that’s absolutely not what this has been about.

The major dealer banks already have separate affiliates that are swaps dealers — they’re called “broker-dealers” and “OTC derivatives dealers” (a.k.a. “broker-dealer lite”). In fact, the majority of the dealer banks’ swaps are already booked through their broker-dealer affiliates. For example, Goldman is a BHC because it owns a commercial bank, GS Bank USA. But Goldman doesn’t book a ton of swaps directly in GS Bank USA; the majority of Goldman’s swaps are booked in its broker-dealers (mainly Goldman, Sachs & Co. and Goldman Sachs International) and its OTC derivatives dealers (mainly GS Financial Markets, L.P. and GS Capital Markets, L.P.). 

What’s more, broker-dealers are already “separately capitalized” — most broker-dealers, including Goldman’s, are subject to Rule 15c3-1’s Alternative Net Capital Requirement. So even if Section 716 actually required banks to move their swaps desks to “separately capitalized affiliates” (which it doesn’t), this wouldn’t require the major banks to set up any new entities — which means that Section 716 wouldn’t force the banks to “raise tens of billions of dollars” to capitalize new affiliates, as Lincoln’s supporters rather bizarrely (and falsely) claim. It would simply require the banks to book all their swaps through their broker-dealers and OTC derivatives dealers.

Forcing the banks to book all their swaps through their broker-dealer affiliates also wouldn’t prevent the banks’ swaps desks from benefiting from the Fed’s discount window. It’s true that only depository institutions can borrow directly from the Fed’s discount window; but through the magic of Reg W and intercompany transactions (including intercompany payables and receivables), a BHC could rather easily use its commercial bank’s access to the discount window to benefit its broker-dealer subsidiary. (Yes, 23A and 23B provide some limitations on transactions between commercial banks and affiliates, but 23A and 23B have been so worn down over the years that there are multiple ways they could be circumvented in a stress scenario. For example, the rules on intraday credit are very lax, which a broker-dealer could use to help satisfy any intraday obligations to its clearing bank.)

Moreover, all the major BHCs centralize their liquidity at the holding company level, and all their major trading subsidiaries have parent company guaranty agreements. However, commercial bank subsidiaries of BHCs also rely heavily on their parent companies, both formally and informally. My point is that it's the holding company that matters — this is what Volcker meant when he said, “I tend to think of the bank holding company as the relevant organisation.” The entire BHC benefits from access to the discount window and (to a lesser extent) FDIC insurance, so spinning off swaps desks into separate affiliates serves no purpose. You're accomplishing nothing, while at the same time creating a whole bunch of unnecessary problems/distortions.

For example, contrary to popular belief, Lincoln isn't proposing that banks spin-off all their derivatives dealing — just their swaps dealers. So going through with Lincoln's compromise would arbitrarily bifurcate the regulatory regime for derivatives (again), instead of finally creating a coherent and consistent regulatory regime for derivatives. And for what? Lincoln's compromise wouldn't accomplish any of her stated goals, nor would it make the financial system any safer, as I've explained. No, this is all about Lincoln saving face, and progressives fulfilling their desire to "stand up to Wall Street" on something. Creating an arbitrarily bifurcated regulatory regime has long-term consequences, and it's absolutely not worth doing just so Blanche Lincoln can save face.

Okay, now back to my vacation.