Bank Reform Bait and Switch

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When the Senate bank reform legislation passed in May, Senate Majority Leader Harry Reid (D-Nevada) said it sent the message to Wall Street that they can no longer "recklessly gamble away other people's money." The bill told Main Street, "you no longer have to fear that your savings, your retirement or your home are at the mercy of greedy gamblers in big banks. And it says to them, 'never again will you be asked to bail out those big banks when they lose their risky bets,' " according to Reid.

Reid was correct. The bill the Senate passed did protect the taxpayers from reckless gambling by the big banks, largely due to the last-minute inclusion of strong derivatives reforms authored by Senator Blanche Lincoln (D-Arkansas). So why is it that Senate and House leadership are now busy behind these scenes trying to kill the best provisions in their own banking reform legislation?

Watch the Hands

On Wednesday, a House-Senate conference committee will begin work aligning the two versions of the bank reform bill. Lincoln's proposal to force the big banks to spin off their derivatives desks into another, separately-capitalized corporate entity is the top target of the big bank lobby, which has spent $600 million so far attempting to defeat reform.

Behind the scenes, Senate Banking Chair Chris Dodd (D-Connecticut) and House Financial Services Chair Barney Frank (D-Massachusetts) have made it clear they are not fans of Lincoln's proposal. Neither is the U.S. Treasury Department. Treasury official Michael Barr has been running around telling anyone who will listen that these derivatives rules were not part of the administration's four "core objectives" for financial reform.

But opponents of strong derivatives reform have a big problem. They can't just yank it out of the bill with an outcry from consumer advocates and reform groups like Americans for Financial Reform, who have been working hard on the issue. So they have cooked up a new scheme. They will replace the Lincoln language with the strengthened version of the Volcker Rule offered (but never voted on) by Senators Merkley (D- Oregon) and Levin (D-Michigan). They want to convince everyone that a strengthened Volcker Rule takes care of all the issues raised by Lincoln.

"Zero Overlap" Between Proposals

I asked Jane D'Arista, the former staff economist for the House Banking and Commerce Committees, whether a strengthened Volcker Rule was a fair trade for Lincoln. D'Arista, who is a big supporter of both reforms, says the two measures are simply not interchangeable. "There is zero overlap between the prohibitions in the Volcker Rule and the Lincoln derivative-desk push-out proposal. They are separate reforms designed to do very different things," says D'Arista.

The Volcker Rule deals importantly, but narrowly, with derivatives trading for a bank's own account. This is called "propriety trading," and banks would be barred from trading any financial instrument (mortgage-backed securities and stocks, as well as derivatives) for their own as opposed to a customer's account. Merkley-Levin would make this reform a statutory ban rather than leaving it to the discretion of regulators and would further crack down on Goldman-style conflict of interest trading. But big banks would still be allowed to deal and trade on behalf of their clients and their derivatives business would still be backed by the taxpayer guarantee.

The Lincoln derivatives language tackles another set of issues. D'Arista helped walk me though the Lincoln reforms that are not addressed by the Volcker Rule or Merkley-Levin.

Removes Taxpayer Liability for Wall Street Gambling

According to D'Arista, the Lincoln language "lets banks be banks again." D'Arista can't understand why taxpayers are being forced to back up the business of marketing risky derivatives in the first place. "There was no precedent or understanding in law or practice that this should be the case prior to the 2008 financial crisis, when investment banks reorganized as bank holding companies to gain access to Federal Reserve bailout money," says D'Arista. Lincoln's proposal to force the big banks to spin off their derivatives desks would separate the risky business of marketing derivatives from the Federal Reserve window, FDIC insurance, and the taxpayer guarantee. No other measure in the House or Senate bill does this.

Ends the Shadow Market

Lincoln proposes to spin off the derivatives desks into separately capitalized affiliates. "One of the real virtues of a separate derivatives affiliate is that it increases transparency. If derivatives transactions occur within the bank, they are necessarily off balance sheet as a contingent liability or asset. Even with requirements for clearing and trading standardized contracts on exchanges, it is easier to hide how much over-the-counter business they are doing using non-standardized contracts. This makes it difficult to know the aggregate position of the bank, or have adequate information about its risky trades," says D'Arista. In contrast, Lincoln's language forces these trades to be conducted by a stand-alone affiliate, regulated by the SEC and Commodity Futures Trading Commission (CFTC), that would be required to provide real-time information on its aggregate position and the volume and pricing of trades. Bank affiliates could still serve bank customers. The major loss to banks is their inability to sell and trade without disclosing the prices they charge.

Engenders Competition and Reduces Risk

D'Arista says the Lincoln bill would also engender old fashion capitalist competition in the derivatives market. "Right now, the big banks make up 90 percent of the derivatives market. When they put their trading desks into a separately-capitalized affiliate, the huge capital reserves of the bank itself will no longer be there to back their enormous derivatives positions and the outsized scale of the derivatives market relative to the actual needs of commercial end-users. The smaller capital reserves of the affiliates will tend to shrink banks' share of the market and open the door to other entrants. Plus it expands the list of counterparties in the system, reducing the risk to the financial system as a whole," says D'Arista.

Closes Major Loopholes:

Another big plus is that the Lincoln language closes the $60 trillion foreign exchange swap loophole in the House version of the bill. These derivatives would be treated like any other swap and be subject to mandatory clearing and exchange trading. The CFTC estimates that 90 percent of the derivatives market would be covered under the Senate version of the bill but only 60 percent under the House bill.

Protects States and Localities from Abusive Swaps:

The Lincoln language contains a dozen other incredibly powerful safeguards, including a provision that would impose a "fiduciary duty" on a swap dealer entering into swaps with government entities such as states, municipalities and pension funds; a provision allowing regulators to prosecute persons who knowingly, or with reckless disregard, use false or misleading information to impact the price of any commodity such as food or oil; and a whistleblower protection program at the CFTC to encourage citizens to report fraud and abuse in the financial markets.

House Majority Leader Nancy Pelosi said this week that she supports the Lincoln language and strong derivatives reform. It is hard to believe that Harry Reid will stand by and let the Treasury Department, Dodd and Frank gut the best parts of the bill that he lauded himself.

No Backroom Deals

Campaign for America's Future, CREDO and MoveOn are spearheading a "No Backroom Deals" campaign to force the conference committee to do its dirty work in the light of day. Sign the petition today and let your member of Congress know how you feel about strong bank reform.