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FinReg Conference Committee – Day 1

I’ve been somewhat silent about the kickoff of yesterday’s conference committee on Wall Street reform. That’s because I really don’t think the committee per se matters. I’m happy that it’s being televised and will have some measure of transparency; I’m happy that we know pretty much how it will work (h/t to Kagro X and Tim Fernholz), but I agree with Kagro that the idea that this represents a transparent process is pretty preposterous. The deals won’t happen on camera, put it that way.

You saw one of them yesterday, as Barney Frank and Chris Dodd reached a “conceptual agreement” on a stronger Volcker rule:

The House and Senate have reached “conceptual agreement” on strengthening what’s known as the Volcker Rule in the Wall Street reform bill, House Financial Services Chairman Barney Frank (D-Mass.) said after a conference committee hearing Thursday […]

Frank said that conference negotiators were moving in the direction of Merkley and Levin’s amendment. “I think there’s conceptual agreement. You have several things: You have tough regulation of derivatives, which I prefer much of what the Senate did. You’re going to have a tougher version of the Volcker Rule.” A reporter asked what the tougher rule would look like.

“I would say the general direction that Senators Merkley and Levin were moving in is a direction a lot of people are supportive of, but the final version, we’ll see. It will be tougher than the House. The House simply empowers the regulators. There will be some direction” given to regulators, he said. Conceptual agreements, of course, are much different than final agreements on financial regulatory reform.

We don’t know how far in the direction of Merkley-Levin we can expect yet. “Better than the House” isn’t saying anything at all. The regulations would have to exceed the Senate version to be at all close to Merkley-Levin and legitimate in terms of banning prop trading by the banks.

Similarly, Smart Money claims that the base text, which is mainly the Senate version, includes “a House-passed bill placing new restrictions on mortgage lending, including elimination of prepayment penalties and a requirement that lenders ensure that borrowers have the ability to repay mortgages before offering the loan.” But that’s basically the intent of the Merkley-Klobuchar amendment that was already in the Senate bill. So there’s a bit of double-dealing here to make the bill look like it’s getting tougher in conference without it really changing that much. Similarly, the whining from Republicans about conference getting off to a “rocky start” betrays their belief that the conference should merely empower them to gut the bill.

So far, I would say that nothing’s really changed, and much remains up in the air. The biggest fight in the bill will be over Section 716, the measure forcing a spin-off of those lucrative prop trading desks so they will be adequately capitalized and walled off from the traditional banking system. Curiously, Smart Money attributed the “conceptual agreement” to that measure, unlike Ryan Grim’s attribution to the Volcker rule, showing just how slippery this whole thing is. Dodd and Frank stated support for Blanche Lincoln’s derivatives title, but weren’t specific enough about Section 716 to draw any conclusions.

“At this point here, I’m supportive of what she has in the bill,” Dodd said. “We need to work from here; we need to figure out where our colleagues are, whether or not there are some modifications that can be made.” […]

Lincoln, who authored the provision requiring banks to spin off their derivatives desk to affiliates, said Wall Street firms need to choose whether they are banks or want to engage in more risky behavior.

“This provision makes clear that derivatives dealing is not central to the business of banking,” said Lincoln, whose win in the Democratic primary in Arkansas earlier this week is expected to strengthen support for the provision.

There will be attempts to weaken the whole derivatives title – Collin Peterson (D-MN), chair of the House Agriculture Committee, defended his own work at the conference committee, arguing for more end user exemptions and striking “complex and confusing” Senate language.

But 716 is the whole ballgame here, as Jane D’Arista explains (you should read all of this to familiarize yourself with the issues involved):

Because the largest U.S. commercial banks were dominant players in the OTC derivatives markets, Federal Reserve lending, FDIC guarantees and taxpayer bailouts during the 2008 crisis gave explicit protection to both bank and non-bank swap dealers and major swap participants. Those protections are not grounded in the traditions and practices of U.S. financial law and regulation. They are no more appropriate than would be an extension of federal protection to financial entities (including bank affiliates) that market and trade corporate stocks and bonds. Recognizing how far the government’s response in 2008 deviated from the existing rational framework for government intervention, Section 716 of the Senate bill makes clear that such protections are not to be given statutory approval; that allowing banks to continue to deal and trade in derivatives would be to accept this egregious violation of prudential standards in legislation intended to reform and strengthen a fragile financial system.

The movement of the largest banks into the business of marketing and trading OTC derivatives occurred during a period when the process of deregulation was sweeping away traditional regulatory barriers and was not challenged. That fact should not, however, lead to the assumption that this is a “normal” banking activity. There is no economic or systemic reason why derivatives should be sold by banks. As the entry of large investment banks into the business in the 1980s suggests, it is not tied to the traditional deposit-taking and lending activities of banks or to the payments system. It is, in fact, so esoteric an activity that, currently, only five institutions account for 90 percent of the market. The remaining 8,000 or so U.S. banks do not sell derivatives or trade them for their own account […]

By shifting the activity to affiliates, section 716 eliminates the burgeoning counterparty risk the largest banks incur through marketing and trading OTC derivatives. Encouraging an expansion in the number of dealers will help reduce the risk to the system as a whole. The intent in both the House and Senate bills to require clearing and trading on exchanges using a central counterparty structure is another critical element for alleviating interconnectedness but only if the pressure to create loopholes is resisted.

And so you cannot really say that the Lincoln derivative title survived conference unless 716 survives as well. And despite the conventional wisdom, nobody involved has moved in that direction, and the “grand bargain” of a stronger Volcker rule in exchange for cutting 716 remains operative. Lincoln will have to actually threaten to withhold support in order to get her way on this, and she has not been willing to do that throughout this process.

The conference committee resumes next week.

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David Dayen

David Dayen