Frank: The ‘Essence’ Of Lincoln’s Derivatives Spin-Off ‘Will Happen’

When she’s not looking to weaken capital requirements for the benefit of her state’s biggest bank, Sen. Blanche Lincoln (D-AR) has been doing good work on financial regulatory reform, as she authored a title on derivatives reform that is stronger than its House counterpart, and would help bring transparency to this currently opaque market.

Lincoln’s title is worthwhile because it forces almost all derivatives trades onto public exchanges (like the stock exchange) and through clearinghouses (which ensure that each party in a trade has collateral should the trade go sour). These steps help both investors and regulators see what is happening, driving down prices and making it easier to police financial shenanigans.

But Lincoln’s bill also includes what’s known as Section 716, which would require banks to place their derivatives trading desks in separately capitalized entities, divorced completely from the banks’ federally insured deposits. House Financial Services Chairman Barney Frank (D-MA), who is also chairing the ongoing financial reform conference committee, had initially expressed opposition to the measure, saying that it “goes too far,” but he is now saying that Lincoln’s goal of getting derivatives away from traditional banking “will happen”:

The essence of what Senator Lincoln wanted to do on pushing derivatives out of the banks will happen, and certainly they will be totally insulated from any insured deposits.

The financial services industry is fighting the spin-off provision tooth and nail, and it’s really no surprise considering that “selling over-the-counter derivatives is among the most lucrative businesses for the largest financial companies.” In fact, U.S. banks held derivatives with a notional value of $212.8 trillion in the fourth quarter of last year. JP Morgan, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley hold 97 percent of that amount. BusinessWeek estimated that JP Morgan and Citigroup have the most to lose from Lincoln’s provision:

JPMorgan had 98 percent of its $142 billion in current value derivatives holdings inside its bank in the first quarter of this year while Citigroup had 89 percent of $112 billion, the records show…Morgan Stanley and Goldman Sachs Group Inc., each of which entered the commercial banking business in 2008 in the midst of the financial crisis, would be less affected. Morgan Stanley kept just over 1 percent of its $86 billion in derivatives holdings in its bank in the first quarter, and Goldman Sachs Group’s held 32 percent of its $104 billion.

As Kansas City Federal Reserve President Thomas Hoenig and Dallas Federal Reserve President Richard Fisher wrote, that kind of risky trading “should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk.” And it’s looking more and more like such a division could actually become the law of the land.