Could Volcker Provide A Boost To Lincoln’s Derivatives Spin-Off Provision?

One of (if not the) most reviled portions of financial regulatory reform for the banking industry is a provision authored by Sen. Blanche Lincoln (D-AR) that would require banks to spin-off their derivatives trading desks into separate entities, with their own capital, or lose their access to federal insurance. Sec. 716 has not only caused the banks consternation, but has garnered the opposition of the Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corp.

For months, the financial services industry has been assuming that the provision would be stripped out of the legislation, first on the Senate floor and then in conference committee. However, according to the Financial Times, the banks are readying themselves to ultimately lose this debate, as former Federal Reserve Chairman Paul Volcker — who has been a key player in the regulatory reform fight — has softened his initial criticism of Lincoln’s measure:

Defeat, which would be a further blow to Wall Street, has been made more likely by Paul Volcker, the influential former Federal Reserve chairman, softening his opposition to the provision…Although he declined to say whether he now supported it, Mr Volcker told the Financial Times that his earlier criticism was based on the belief that a stricter spin-off was in the works and it was now a “relevant question” whether damage would be done if swaps desks could be kept within a bank holding company. “I tend to think of the bank holding company as the relevant organisation,” he said.

As David Dayen put it at Firedoglake, “I see nothing here to guarantee the preservation of Section 716. But this is clearly a crack in the establishment, which lined up quickly and united their opposition to the measure.” Indeed, with the regulators all weighing in against it, it will still be a heavy lift to get the provision into the final bill, but Volcker saying that it could be workable is undeniably a boost, as is the support of Kansas City Federal Reserve President Thomas Hoenig, who said last week that trading in derivatives is “generally inconsistent with the funding subsidy afforded institutions backed by a public safety net.”

This provision means real money for the biggest banks, particularly Bank of America and JP Morgan, so they’ve been “apoplectic” about it. But they’re dealing with both the economic argument for the spin-off, which rightly asserts that banks should not be able to benefit from a federal backstop while trading in risky instruments for their own benefit, and the political reality that Lincoln has a tough reelection campaign coming and needs to score some legislative victories.

Volcker’s softening reflects the reality that the spin-off provision would not prevent banks from hedging risks via derivatives (like early reporting said it might), but only from making markets. In fact, that’s one of the more attractive features of the spin-off: the banks will become customers in the derivatives market, so they’d have as much incentive as anyone else in creating a functional market with low prices.

Volcker said that he is canceling his summer vacation to be on-hand to provide advice to lawmakers as financial reform enters its endgame. “Normally I go to Canada — where the banking system is all healthy and straightforward,” he said.