June 11, 2010
Chairman Christopher Dodd
Chairman Barney Frank
Re: Support Senate Derivatives Reform Sec. 716: Separation of swaps dealing from taxpayer-protected banks
Dear Senator/Representative:
We write on behalf of Americans for Financial Reform, an unprecedented coalition of over 250 national, state and local groups who have come together to reform the financial industry. Members of our coalition include consumer, civil rights, investor, retiree, community, labor, religious and business groups as well as Nobel Prize-winning economists. We write to express our strong support for maintaining the Senate financial reform bill’s Section 716 policy of protecting taxpayers from losses in the $600 trillion derivatives market through a mandatory separation of swaps dealing from taxpayer-protected banks.
Reckless swaps and derivatives trading played a critical role in the financial crisis, turning the fallout from the crash of the domestic housing market into a global economic catastrophe. As the House and Senate conference committee sit down to align their respective financial services bills, Americans for Financial Reform believes that making section 716 a part of the final bill is a critical element of enhancing the security of our financial system, and refocusing our banks on sound lending to consumers and businesses.
No More Gambling with Taxpayer Money
The five largest banks in the United States — Goldman Sachs, Morgan Stanley, JP Morgan Chase, Citigroup and Bank of America — have anticompetitive control over 90% of the U.S. swaps and derivatives market. Currently, these five bank-dealers can fund their swaps trading units with FDIC-insured deposits. They have access to the Federal Reserve’s discount window, which allows them to borrow money for gambling in swaps at near-0% interest rates. Ironically, these government supports were originally created to reassure the public that their deposits are safe, and to protect banks from runs on their deposits — not to help banks finance their own Wall Street casinos. Section 716 of the Senate derivatives title will end this subsidy of these giant players risky derivatives business.
More Bank Capital for Main Street Lending
In effect, Section 716 will require the five largest swaps dealer banks to spin off their swaps desks into separately-capitalized affiliates. As a leading global investor surveyed by Bloomberg News notes, this ―would ensure that capital is not taken from other banking areas and used to meet regulatory requirements of derivative trading or cover the losses being experienced in derivative trading….This will mean that capital needed for the real economy, personal and corporate lending, won’t be taken up by fictitious investments.”
Contrary to industry lobbyist claims, if Section 716 is implemented, banks will still be able to serve their customers in the same manner they always have. Their affiliated swaps desks will still be able to sell a full range of financial products and they will still be able to hedge their own risks. Under the Senate bill’s comprehensive exchange-trading regime, banks will use the exchange-traded futures market to hedge risk like any other market participants. However, unlike today, customers’ deposits and savings accounts – and the banks’ ordinary lending business – will be protected from the fallout from highly risky swaps transactions.
Unique Strengths of Section 716
First, Section 716 requires the big banks to spin off their derivatives desks, which would separate this risky business from the Federal Reserve window, FDIC insurance, and the taxpayer guarantee. No other measure in the House or Senate bills protects the taxpayers in this manner.
Second, Section 716 increases competition. Currently, the big banks make up 90% of the derivatives market. Requiring the big banks to put their trading desks into separately capitalized affiliates will bring transparency to the pricing of derivatives, remove the unfair subsidy provided by the commercial banks special privileges, and will encourage competition from other entrants into the market.
Third, Section 716 increases stability in the system. Capital inadequacy was a key cause of the financial crisis. The additional robustness of the capital requirements created by housing derivatives desks in separate entities will reduce risk by shrinking the enormous exposure of a few very large banks that can threaten the stability of other financial institutions. It will reduce the artificial financial leverage of the products Warren Buffet has called “weapons of mass financial destruction” — and will greatly increase stability in the system.
Finally, Section 716 reduces counterparty risk in the system by shifting risk to smaller institutions and encouraging participation by more counterparties. Even if the spun off institutions in which derivatives desks will be housed are affiliates of the big banks, they will be substantially smaller than the banks and will have smaller capital reserves. This means that non-bank entrants, who are currently locked out of the market because they cannot compete with big banks, will be encouraged to participate. This will increase the number of counterparties and, therefore, lower risk across the system. The fact that the Bank of International Settlements estimates 31% of all OTC derivatives transactions are between dealers means that the symbiotic relationship among these five major banks remains a ticking time bomb. If one ―too big to fail‖ bank collapses, it can cause the collapse of another behemoth bank, and ultimately lead to another economic crisis.
Merkley-Levin Not A Substitute
AFR strongly supports the Volcker Rule and the amendment to strengthen it, offered by Senators Merkley and Levin. However, these provisions are not interchangeable with Section 716. The Volcker Rule deals only with propriety trading (when Goldman-Sachs for instance, trades for its own account). Augmented by Merkley-Levin, the Volcker Rule would comprehensively ban bank holding companies and subsidiaries from engaging in this type of trading, and would further crack down on Goldman-style conflicts of interest in securities trading. But without Section 716, banks will still be able to divert capital from their core business to “make markets” in derivatives, exposing taxpayers to future bailouts. These two provisions are complementary and together move the bill towards the type of structural reform that is sorely warranted by the greatest financial crisis since the Great Depression.
Thank you for considering the Americans for Financial Reform position on these important issues. For more information on derivatives reform, please contact Heather Slavkin, AFL-CIO, at 202-637-5318 or hslavkin@aflcio.org.
Sincerely,
Americans for Financial Reform