WASHINGTON — A little-noticed provision tucked into regulatory reform legislation by the Treasury Department is causing a furor among large institutions, which say it would effectively ban all derivative transactions between banks and their affiliates.

While the Obama administration argues the provision would make the system safer, bankers say it would do the exact opposite by preventing them from using a risk-reduction tactic blessed by regulators.

"The dual purpose of the overall legislation is to address the causes and consequences of the financial crisis and to reduce systemic risk in the future - yet this provision fails both tests," said Michael M. Wiseman, the head of Sullivan & Cromwell's financial institutions group. "This had nothing to do with the crisis and enactment of this provision would, in fact, diminish the ability of affiliated companies to manage risk on a consolidated basis and, at the same time, could exacerbate interconnectivity among unaffiliated financial institutions."

At issue is a provision that would cover derivatives under Section 23A of the Federal Reserve Act, which restricts a bank's transactions with any single affiliate to 10% of the bank's capital and aggregate transactions with affiliates to 20% of the bank's capital stock and surplus. Under the statute, banks have to fully secure any credit exposure to an affiliate.

Under current law, most derivatives are not treated as a credit exposure, and thus not subject to the statute, but the Treasury successfully included a provision changing that in the House regulatory reform bill passed in December. A draft bill from Senate Banking Committee Chairman Chris Dodd introduced late last year also included the provision, and industry sources expect it to be part of a revised version due out soon.

But industry lobbyists accuse the administration of pretending the provision was little more than a technical change, and most lawmakers are unaware it is even part of the reform bill.

"The provision was put in there by the Treasury and passed in the House bill and it sort of was a sleeper, because it was represented as technical housekeeping amendments," said a former regulator who spoke on condition of anonymity. "In fact it's not. It's much more radical. It really kind of took the industry by surprise. By the time they finally noticed, it had already passed in the House bill before they even realized it was there and figured out what the impact would be on their business, so now it's at a pretty critical juncture."

Bank lawyers, analysts and former regulators said the provision could drastically affect their business. They said that since banks routinely make back-to-back derivatives trades with affiliates throughout the day as a hedging tool, the current business model would easily surpass the 23A caps and effectively prohibit trading with affiliates. As a result, banks will have to offset risk with third parties, they said.

"It's enormous. It's one of the biggest issues in reg reform," said an industry lobbyist who spoke on condition of anonymity. "It will totally change banks' ability to manage risk."

Currently, banks enter into transactions with multiple affiliates but conduct back-to-back trades to put the risk into one place so the holding company can centrally manage it.

"If you can't do back-to-back transactions because you are limited in your exposure … it creates basis risk," the lobbyist said. "It makes it harder to hedge risk and it's a massive systemic problem."

The Obama administration, however, argues the provision would make the system safer and is long overdue. It said the provision will ensure FDIC-insured banks are not overexposed to derivatives transactions with affiliates.

"The fundamental reason why we proposed this reform is to protect FDIC-insured depository institutions in their transactions with affiliates and to prevent the spread of the subsidy inherent in the bank safety net to affiliates," said an administration official who could not be named. "23A today covers loans and guarantees banks provide to affiliates but does not cover derivatives. Credit exposure is credit exposure, regardless of form. If a transaction generates credit exposure of a bank to an affiliate, it should be covered. We've got to close the derivative loophole in the 23A framework."

Karen Shaw Petrou, the managing director of Federal Financial Analytics, said that the Treasury provision makes sense from a policy perspective since it would address credit exposures that are not currently covered.

"What Treasury did was rightly recognize that credit risk now comes in many other ways," she said. "That is a business model changer, and one of the reasons credit risk comes in many other ways is that those ways invaded the old controls designed to curb particularly concentration risk. … The real effort here is to deal with real risk."

The administration also argues the provision would force large financial conglomerates to become less complex, making it easier to isolate and handle problem units without jeopardizing the bank.

"We view this reform as part of our policy to end 'too big to fail,' " said the administration official. "This proposal would reduce the internal complexity of the largest banking firms so that if and when they go down, resolving them will be an easier task."

But bankers, for whom the provision would be costly and burdensome to implement, counter that the proposal aims to fix a nonexistent problem that had nothing to do with the crisis. They say it would take away a popular risk management tool encouraged by their regulators, and could actually undercut the point of reform by increasing interconnectivity with third parties.

Gil Schwartz, a former Fed lawyer and now a partner with Schwartz & Ballen, said that forcing banks to offset derivatives risk with third parties would be much less efficient and would greatly increase the cost to the institution.

"It is going to be a lot more costly," he said. "It is a lot more efficient for the bank to write one derivative transaction with its affiliate which covers a whole multitude of transactions that the affiliate has entered into."

Also at issue is the language in the provision itself, which bankers see as open-ended. For example, the provision would force bankers to include current exposures plus a measure of potential future exposures against the transaction limits, but those measures are unclear.

"What the heck is 'ascertainable potential credit exposure resulting from the transaction'? " said Kip Weissman, a partner with Luse Gorman Pomerenk & Schick PC. "This is the type of ambiguity that is supposed to be eliminated by the bright line quantitative tests of 23A. So if Congress wants to give the regulators flexibility they should just rely on 23B, which already gives them strong tools to regulate affiliate transactions."

Indeed, industry lobbyists argue the Fed could have already covered derivatives under its existing regulatory authority — but chose not to.

The Fed, which was specifically directed by Congress to address derivatives under the Gramm-Leach-Bliley Act of 1999, included derivatives trades under Section 23B, which requires transactions with affiliates to be conducted at arm's length. Though it said credit derivatives should be treated as a credit exposure, it decided not to include other types of trades.

"The Fed was directed to address it in GLB and it essentially backed down," said Oliver Ireland, a partner with Morrison & Foerster LLP who was a lawyer at the Fed at the time.

Large financial companies threatened to move their business offshore if all derivatives were covered, he said.

"The Fed didn't want to make them covered transactions because of the pushback and the effect it was going to have on banks," Ireland said. "Nothing has changed with the economics of the world since then. But [the administration] has come back and they are tightening up and they are applying this to derivatives and the effects could be pretty dramatic."

The administration acknowledges the Fed could subject all derivatives to the interaffiliate transaction limits but wants to compel the central bank to act.

Robert Mannion, a former deputy general counsel with the Fed that specialized in 23A and B issues and is now a lawyer with Arnold & Porter LLP, said the Fed should have clamped down harder years ago.

"It seems to me a reasonable proposal to subject them to affiliate restrictions; then if there is a need for exemptions of some kind, the regulators can issue exemptions," Mannion said. "I think you have to look at what the exposure is out there, and I don't think that has been done yet."

Richard Carnell, an associate professor at Fordham University School of Law, said the administration's proposal makes sense.

"Credit exposure is just as real on a derivative as on a financial guarantee. For the law to restrict one and ignore the other is downright silly," he said. "Opposing any quantitative limit on derivatives exposure would exemplify the sort of special-interest politics that set us up for the financial debacle."

Industry lobbyists would like to see the provision dropped altogether but are trying at least to persuade lawmakers to let the bulk of transactions be exempt from the restrictions. With most of the focus on the reform bill going toward other issues, their chances of success are unclear.

"Such types of relief could potentially make the application of the rule less disruptive to banks' use of interaffiliate derivatives as a risk management tool. Of course, the devil is always in the details," said the former regulator.

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