Financial Reform: Hope Lives for Blanche Lincoln's Derivatives Ban

(MoneyWatch)  A compromise may be in the works over Wall Street's use of derivatives. Sen. Blanche Lincoln, one of the lawmakers ironing out differences in the House and Senate financial reform bills, has refined her legislative proposal to highlight that big banks can keep their swaps businesses -- in separately funded units:

Although it appears to water down the proposal, the proposed change would be costly for Wall Street. Banks would have to set aside billions of dollars to protect against losses in these affiliates. The provision doesn't specify the capital requirements, which would likely be decided by a bank regulator.

That last part is worrisome. Although there's a move afoot among financial regulators around the world to raise bank capital standards, U.S. watchdogs can't be counted on to set sufficiently high thresholds to cover potential derivatives-related losses. Also, the plan doesn't appear to lessen the risk of major swaps dealers being interconnected.

Still, it's a worthwhile concession if it keeps Lincoln's plan alive, even in denuded form. Under the new proposal, big banks also would have two years to segregate or dump their derivatives business, while community banks would be exempt.

The major goal here is to limit Wall Street from speculating on derivatives while retaining access to federal financial support, such as the right to borrow on the cheap. Allowing these institutions -- Bank of America (BAC); Citigroup (C); Goldman Sachs (GS); JPMorgan Chase (JPM); Morgan Stanley (MS) -- to stay in the swaps business would let them continue selling derivatives to customers for hedging purposes.

Of course, serving customers was always a fig leaf for Wall Street. The proof is that banks are now training their fire on the revised derivatives plan:

On Monday, Mrs. Lincoln offered to ease some of the toughest elements of her provision, but not enough to assuage Wall Street's concerns....

[T]he six largest Wall Street banks, which dominate the derivatives trading business, quickly indicated that they would lobby fiercely to defeat the entire provision.

Against all odds, meaningful derivatives reform has a chance. Paul Volcker last week tempered his previous opposition to Lincoln's plan. Federal Reserve bank chieftains Richard Fisher and Thomas Hoenig also recently signaled their support.

Hoenig, the outspoken president of the Kansas City Fed, said in a June 10 letter to Lincoln that banks' swaps desks "should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk."

Sounds like a plan.

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