The derivatives rules in the Senate financial reform bill pose a serious threat to the financial system because they leave critical institutions — including but not limited to derivatives clearing houses — without a lender of last resort. A major feature of the legislation prohibits any "swaps entity" from receiving federal assistance such as deposit insurance or access to the Federal Reserve's lending facilities. The bill will force banks to spin off their derivatives activities into separate corporate entities. Yet, sweeping the risks inherent in derivatives trading off bank balance sheets does not make them disappear.

In our view, the powers of the central bank as lender of last resort should continue to be available so that the government is prepared to respond in a timely, cost-effective way to dire threats. Section 13(3) of the Federal Reserve Act currently provides for such emergency lending. Proposed oversight by a proposed systemic-risk council might improve the use of such Fed lending facilities, and would highlight the central role of the Treasury in quasi-fiscal decisions. However, it makes no sense to operate a large portion of the financial system without access to the lender of last resort. Systemic intermediaries and institutions will still expect to be protected by government in a crisis.

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