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From Securities Regulation Daily, March 7, 2013

House and Senate Legislation Would Repeal Bank Swaps Push-Out Provision of Dodd-Frank Act

By Jim Hamilton, J.D., LL.M.

Bipartisan legislation has been introduced in the House and Senate to modify Section 716 of the Dodd-Frank Act, the bank swaps push-out provision. In the House, the Swaps Regulatory Improvement Act was introduced by Reps. Randy Hultgren (R-Ill) and Jim Himes (D-Conn), members of the Financial Services Committee, and Reps. Richard Hudson (R-NC) and Sean Patrick Mahoney (D-NY), who serve on the House Agriculture Committee. The legislation would amend Section 716 to ensure that federally insured financial institutions can continue to conduct risk-mitigation efforts for clients like farmers and manufacturers that use swaps to insure against price fluctuations. The bill modifies Section 716 to allow commodity and equity derivatives in banks with federal deposit insurance. Senate Banking Committee members Senators Kay Hagen (D-NC) and Patrick Toomey (R-Pa), along with Agriculture Committee members Senators Mike Johanns (R-Neb) and Mark Warner (D-Va), have introduced companion legislation.

This legislation mirrors the final version of H.R. 1838 that the Financial Services Committee unanimously reported out to the House in the 112th Congress. An amendment to H.R. 1838 offered by Rep. Himes, and unanimously approved by the Committee, carved out risky instruments, such as structured swaps and asset-backed securities, and is included in the Swaps Regulatory Improvement Act of 2013. These are swaps that are the most risky and should be pushed out of banks.

Currently, under Section 716, federally insured banks would not be permitted to conduct certain swaps trading, including trading of commodity, equity, and credit derivatives, thus compelling the banks to push out that activity into separately capitalized non-bank affiliates. By prohibiting this activity in federally insured institutions, regulators would lose some oversight. This legislation will ensure that these swaps take place within institutions that are more closely monitored by federal regulators.

Under Section 716, insured depository institutions must push out all swaps and security-based swaps activities except for specifically enumerated activities, such as hedging and other similar risk mitigating activities directly related to the insured depository institution's activities. Section 716 prohibits federal assistance, including federal deposit insurance and access to the Fed discount window to swap entities in connection with their trading in swaps or securities-based swaps. This section would effectively require most derivatives activities to be conducted outside of banks and bank holding companies.

When Congress was crafting the Dodd-Frank Act, financial regulators raised concerns about the risk involved with this provision. For example, then–FDIC Chairman Sheila Bair said that if all derivatives market making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less-regulated and more highly leveraged venues.

The legislation is designed to ensure that derivatives trading units can be overseen by financial regulators and increase the capital available to finance job creation and economic activity.

The securities industry supports the legislation as a bipartisan, bi-cameral recognition that Section 716 was an ill-conceived provision, one that elicited strong reservations from multiple federal prudential regulators when originally adopted and still today. According to SIFMA, the legislation will forestall a misguided action that would force swaps to migrate to other entities that are not subject to prudential regulation, and could likely increase systemic risk instead of reducing it.

The author of Section 716, former Senator Blanche Lincoln (D-Ark), refuted the suggestion that this provision will push derivatives trading off into the dark without oversight. Title VII of Dodd-Frank makes it abundantly clear that all swaps activity will be vigorously regulated by the SEC and CFTC. Just because these swaps desks will no longer be overseen by the FDIC does not mean that they will not be subject to strong regulation by the SEC and CFTC, said the senator. Similarly, Sen. Lincoln refuted the suggestion that Section 716 will prevent banks from using swaps to hedge their risks. Banks that have been acting as banks will be able to continue doing business as they always have under the reform legislation, she assured, with banks using swaps still being allowed to hedge their interest rate risk on their loan portfolio (Cong. Rec., May 5, 2010, p. S3140).

Derivatives DoddFrankAct

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