WASHINGTON — Of the myriad issues facing banks in the Senate regulatory reform bill, a provision to force divestment of swaps desks may be the most contentious.
Banking industry representatives argue the provision would be counterproductive, effectively increasing risk by forcing derivatives trading overseas or into less-regulated institutions such as hedge funds.
Although they hope support from federal regulators in recent days may help persuade lawmakers, their chances to remove the provision remain uncertain.
Sen. Judd Gregg, who is prepping an amendment to strip the measure, said it may fail because of fears of political backlash for supporting large banks.
"We are in such a lynch-mob mentality towards anything banking," the New Hampshire Republican said in an interview. "There is no coherent thought process in how Congress deals with the whole issue of financial regulation right now. It's who can shout the loudest and be the most populist. I would like to think that mature, thoughtful positions would prevail in financial regulation, but I don't know that it will."
Gregg said the provision will increase, not reduce, risk in the system and spur a credit crunch.
"Instead of strengthening the market and making it sounder, it will actually make it weaker and push a lot of business offshore and it will directly affect Main Street, because it will cause a contraction in credit," he said. "There is no question but that if you spun these desks off, the capital needed to support these desks in other places would come out of other credit opportunities … and as a practical matter, you would end up costing a lot of jobs on Main Street."
Until recently, bankers confidently predicted the provision would not be in the final version of the regulatory reform bill.
Senate Agriculture Committee Chairman Blanche Lincoln, D-Ark., unexpectedly added it to her derivatives bill last month, and that legislation was to be folded into the regulatory reform measure. The provision would require any financial institution that receives government help — including deposit insurance and access to the Federal Reserve Board's discount window — to spin off its swaps trading desk.
The Obama administration initially appeared opposed to the provision, and most lobbyists assumed it would be removed before Senate Banking Committee Chairman Chris Dodd moved his reform bill to the floor. Instead, the provision has survived to become a flashpoint of debate, and the administration has tried to remain neutral.
Asked about it again Tuesday, Treasury Secretary Tim Geithner, who has vast experience with derivatives from his former role as president of the Federal Reserve Bank of New York, would not say where he stood on the issue.
"We have not taken a position on that specific provision now," Geithner said at a Senate Finance Committee hearing. That posture infuriates Gregg, who was once nominated to serve as Obama's secretary of commerce. The administration's job is to protect the U.S. financial system, Gregg said.
"Treasury is in hiding. They are out behind a tree somewhere," he said. "It's very discouraging. They should be aggressively pointing out the dozens of unintended consequences of this but for political reasons … they are not.
"It's frustrating going into what is arguably the most important exercise in rewriting our financial regulations in this country and to have the Treasury basically be a nonplayer on core issues that will have a major impact and do fundamental harm to the vitality of our economy."
The industry has received support from Federal Deposit Insurance Corp. Chairman Sheila Bair, who warned in a letter to Lincoln last week that the provision would increase risk in the financial system.
"If all derivatives market-making activities were moved outside of the bank holding companies, most of the activity would no doubt continue, but in less regulated and more leveraged venues," she wrote.
Bair also defended banks' need to use derivatives to hedge risk, warned against creating new opportunities for regulatory arbitrage and said that pushing derivatives into nonbank affiliates would reduce the amount of quality capital. She said the provision would ultimately make it harder for regulators to monitor risk.
"One unintended consequence of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund, which I know is not the result any of us want," she said.
Bank lobbyists are hopeful that because Bair is known for being tough on big banks, her arguments will have more credibility with lawmakers.
But so far it is difficult to gauge the impact of Bair's letter. Dodd's office has deferred questions on the measure to Lincoln, whose office did not respond to requests for comment.
Other Democrats are in a holding pattern.
Sen. Mark Warner, D-Va., took to the floor last week to warn that the provision could push the derivatives market offshore, but he has been silent since Bair's letter became public Monday to see if her concerns squash the provision.
Sen. Kirsten Gillibrand, D-N.Y., had prepared amendments before the committee vote on the bill to study the issue, but did not offer them. Her office did not respond to requests for comment.
The exact impact of the bill also remains unclear as different sources analyze the legislation differently.
According to some, the bill would only require banking companies to spin out their derivatives units and place them under a nonbank subsidiary or with an affiliate.
But industry representatives said the provision goes even further, and would prevent a bank from using a derivative for relatively common practices, such as hedging against the credit risk of a pool of loans.
"This is a major provision that has very serious ramifications not just for banks or swaps dealers but for the economy as a whole," said Cory Strupp, a managing director with the Securities Industry and Financial Markets Association. "This is the kind of thing that needs to be considered very carefully before it is enacted into law. We can't afford to enact provisions and then see what happens. The damage can be too great."
Some analysts said Dodd and Lincoln may still work behind the scenes to soften the provision. That may help explain why the administration has not publicly weighed in, they said.
"From the administration's perspective, you now have the FDIC and the Fed as being opposed, and you have moderates on both the Republican and Democratic side of the aisle," said Jaret Seiberg, an analyst with Washington Research Group, a division of Concept Capital. "If you are Treasury and you can get other people to take care of the problem for you, why wouldn't you?"