Banks vs. Congress: The Financial Reform Endgame Approaches

The battle between America's banks and its politicians moves to a new stage Tuesday as a congressional conference committee, made up of leading financial experts from the House and Senate, begins drafting a compromise financial reform bill. The measure has been described as one of the most important pieces of legislation to emerge since Congress passed health care insurance reform earlier this year.

One of the key questions facing Congress is this: Three years after the financial crisis began, how much risk should America's banks be allowed to take? They received nearly $800 billion of rescue money from taxpayers at the height of the crisis, but they're now making healthy profits again and oppose having any handcuffs put on their lucrative businesses. Congress, facing populist outrage at elections in November, now wants to be seen as tough on Wall Street and is threatening to rein them in.

Years in the making, separate versions of the financial reform bill that the House and Senate have passed are now being reconciled. Lawmakers from both chambers broadly agree on the need to protect consumers from risky financial products and for a government watchdog to provide advance warning of another crisis before it can threaten to destabilize the global financial system.

"It will ensure that all financial practices are exposed to the sunlight of transparency, so that exotic instruments like hedge funds and derivatives don't lurk in the shadows, and businesses can compete on a level playing field," predicts Sen. Christopher Dodd (D-Conn.), chairman of the Senate banking committee.

Derivative Trading Is in the Spotlight

The battle lines have been drawn over two separate provisions dealing with banks' ability to keeping trading in derivatives, risky bets based on an underlying financial product such as equities or bonds. The financial industry opposes any efforts to limit derivatives trading. They say any restrictions will simply force the business to move overseas. Opponents say the banks should no longer be allowed to gamble with depositors' money and be put in another situation where they need a taxpayer-funded bailout.

It was risky derivatives trading that forced insurance giant AIG Group to veer into insolvency at the height of the financial crisis, requiring a $180 billion taxpayer bailout.

One provision in the proposed conference bill was first suggested by Paul Volcker, the former Federal Reserve chairman who now serves as an economic adviser to President Obama. His proposal, dubbed the "Volcker rule," would ban government-insured banks from owning hedge funds and private equity firms. The former take highly speculative bets on stocks, bonds, currencies and commodities, and the latter invest in troubled companies, fix them up and sell them for a profit.

The Volcker rule would also ban "proprietary trading," meaning using the bank's own money to speculate in the markets. This would include a ban on derivatives trading.

Only Five Big Banks Affected?

Volcker told CNBC on Monday that he understood that the proposed legislation would force banks to divest their derivatives businesses into separate entities. "It's very hard to make a distinction between a bank, a holding company and an affiliate," Volcker said. "They are all together under common management, all mutually supportive, and it may be useful to have a particular activity separated out."

Volcker said the ban on proprietary trading would affect only about five large Wall Street banks, which account for the bulk of the derivatives business.

The second controversial proposal, by Sen. Blanche Lincoln (D-Ark.), would require banks to move their swaps operations into an affiliate company. Swaps are transactions where institutions trade a financial instrument. For example, banks have longed traded in swaps on interest rates, where one bank would exchange a fixed-rate instrument for a floating-rate instrument in order to reduce risk, a process known as hedging.

While other derivatives such as options and futures are traded on exchanges, the vast majority of the $600 trillion in outstanding derivatives traded by banks are swaps, so the Volcker proposal and the Lincoln plan are overlapping, and it's not clear how that conflict will be resolved.

Bendable Rules

Lincoln originally wanted to ban banks from the swaps business entirely, but the financial industry raised an outcry, and after heavy lobbying, a compromise was reached to allow banks to place swaps into an affiliate company, which would be legally separate from the bank but still owned by the parent holding company.

The distinction now is that the affiliates would no longer have the ability to approach the Federal Reserve for an emergency loan, as deposit-taking banks can do now. A Senate aide says the new proposal would ensure that depositor funds are never placed at risk.

But not everyone agrees with that view. "There are rigid rules against banks lending to affiliates, and those rigid rules were relaxed considerably by the Fed in the crisis," says Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University. "I have no confidence that given the next crisis the same rules would not be relaxed again."

Hurley says that while he supported the original Lincoln plan to divorce banks from swaps, he's concerned now that by shifting the business into an affiliate, the bank would still feel a moral responsibility to support it, and the Fed and Treasury would feel morally responsible for the bank.

"At the end of the day, the bank holding company isn't going to let the affiliate go, and the Fed isn't going to let the holding company go, so we are back to where we were at the start of the process," Hurley says.

Where Will Reserve Capital Come From?

Another criticism concerns the amount of capital, the money that bank keeps on its books as a reserve, that would now have to be transferred to the affiliates to conduct their business at proper risk levels.

"Clearly in the last few years, bank capital has been in short supply, so taking $5 billion to $10 billion of capital out of already undercapitalized banks is going to be a tough situation," says Kevin McPartland, senior analyst at research firm TABB group.

Senate aides maintain that the limit on dealing swaps applies to only 25 or so large Wall Street banks that act as "market makers," firms that are always willing to buy or sell a given product. The aides say smaller banks that use interest rate swaps to hedge their risks would keep doing so without setting up an affiliate.

"It's strictly down to political maneuvering now," McPortland says, "and it's hard to say how Congress will decide."