December 23, 2014 | Commentary on Budget and Spending, Federal Spending

CRomnibus Swaps Rhetoric For Reality

Thanks to one tiny provision stuffed into the CRomnibus spending bill, millions are now familiar with the financial term swap. This provision essentially undoes a Dodd-Frank rule known as the swaps push out rule.

That Dodd-Frank regulation – one of several which still had not been fully implemented – forced banks to choose between getting rid of their swaps business or losing access to FDIC insured deposits and the Fed discount window.

For those who haven’t had the pleasure: a swap is a financial contract.

The term swap is used because both parties to the contract agree to pay each other. Thus, at some date in the future, the participants agree to swap cash flows.

As fancy as all this may sound, swaps are nothing more than a contract where two parties agree to pay each other (different amounts) at some later date. They’re derivatives because they derive their value from something else, such as interest rates or bonds.

Swaps ended up with a terrible reputation during the subprime crisis because of AIG’s credit default swaps (CDS). But CDS are only one type of swap, and they have very little to do with the provision in the spending bill.

Unsurprisingly, these facts didn’t stop Sen. Elizabeth Warren, D-Mass., and Rep. Nancy Pelosi, D-Calif., from bashing Wall Street to score political points. (The big banks, already an easy target, sealed that deal by lobbying hard for the rule change.)

And while there is definitely a legitimate policy issue here – banks clearly want to run their swap business through insured depository institutions – Warren and Pelosi are basically spouting absolute nonsense.

For the record, the swaps push out rule, instituted via Dodd-Frank, would have required commercial banks to either stop participating in certain swap transactions or set up a separate entity to engage in those swaps. Failure to do so would have prohibited the banks from receiving two kinds of federal assistance.

The idea behind the original Dodd-Frank provision was (ostensibly) to make the financial system safer by moving these transactions out of the banking system, away from companies with access to FDIC insured funds and Federal Reserve discount window loans.

The rule has been a disaster since it was first proposed, and the CRomnibus provision basically eliminates it altogether. (Fixing the rule has long had bipartisan support. In 2013 House Democrats helped to pass a bill that would have watered down the push out rule.)

Swaps are now being portrayed as the “epicenter of the crisis” and “what brought AIG down.” Supposedly, eliminating the push out rule “allows big banks to gamble with money insured by the FDIC.”

These sorts of criticisms are the perfect combination of myths and exaggerations. To set the record straight, here’s a list of key facts about swaps and the push out rule.

  • The push out rule had nothing to do with the AIG swaps that caused so much trouble. AIG was a regulated insurance company, not a bank. Furthermore, much of the difficulty at AIG stemmed from its securities lending business within its (non-bank) life-insurance subsidiaries.
  •  The overwhelming majority of commercial banks’ swaps are related to interest-rate and foreign exchange risk. These derivative securities are absolutely nothing like the ones that helped bring down AIG – those were tied to residential mortgage-backed-securities.
  • Prior to Dodd-Frank, banks’ swaps activities were heavily regulated. For decades, regulators have blessed these transactions and tailored capital requirements to account for swaps’ risk. For reference, here’s a passage from a 1996 bulletin from the Comptroller of Currency:

Bank management must ensure that credit derivatives are incorporated into their risk-based capital (RBC) computation. Over the near-term, the RBC treatment of a credit derivative will be determined on a case-by-case basis through a review of the specific characteristics of the transaction. For example, banks should note that some forms of credit derivatives are functionally equivalent to standby letters of credit or similar types of financial enhancements. However, other forms might be treated like interest rate, equity, or other commodity derivatives, which have a different RBC requirement.

  • Swaps are not inherently riskier than, for example, making commercial loans to businesses. In some cases, swaps actually lower banks’ exposure to loan risk. Regardless, it is factually incorrect to single out swaps transactions as some sort of unique “gamble” with insured deposits. If we’re going to allow banks to make loans, there’s no justification for disallowing banks to participate in swaps transactions.

 

  • The push out rule would have prohibited banks engaged in swaps transactions from receiving some types of federal assistance, but not all. For example, the rule explicitly stated that it would not prohibit firms from receiving Federal Reserve emergency lending that was part of a broad-based program. These are exactly the types of credit allocation (some would say bailout) programs the Fed employed in the 2008 crisis, and Dodd-Frank enshrined them into law.

Beyond these basic facts, banks of all sizes use swaps for various purposes. There’s no inherent reason that banks – or any company – should be barred from entering into valid contracts with willing partners.

More broadly, this rule highlights exactly what’s wrong with our regulatory system: regulators micro-manage every aspect of private financial firms’ transactions because taxpayers cover (at some level) the firms’ losses.

Markets continually evolve, though, so it should be no surprise that this regulatory approach has become enormously complex.   A consequence of this complexity is that ideas which sound simple – such as limiting the use of swaps – are exceedingly difficult to implement.

One obvious solution to this problem would be to change our laws so that taxpayers no longer cover any aspect of private firms’ losses. Eliminating the Federal Reserve’s emergency lending authority would be a great first step, and eliminating federal deposit insurance would be another.

Federally insuring deposits may sound great to policymakers, but this system introduces moral hazard into the banking system. The ability to attract deposits no longer reflects banks’ true risk exposure, so banks have an incentive to take more risk.

Deposit insurance – as well as expanding its scale and scope during a crisis – is all but certain to make the financial system less stable.

Practically speaking, it would be much easier to protect taxpayers by getting rid of the Fed’s emergency lending powers and deposit insurance than to devise schemes like the swap push out rule. The politics? That’s another story.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes