One of the biggest problems with financial reform is having to discuss issues that most people find painfully boring. For instance, “derivatives.”
But “derivative” is an important word! And the concept is crucially important to both the financial crisis and where reforms need to go. There’s a reason why Warren Buffett said, “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” And why Bill Clinton said he was wrong to avoid regulating derivatives when he had the chance. These financial instruments played a central role in the financial crisis, culminating with the collapse and bailout of AIG.
A key effort in the Dodd-Frank financial reform act has been to bring transparency and reforms to the complex, shadowy market of derivatives. On Wednesday, however, Republicans and Democrats on the House Agriculture Committee approved seven bills that would roll back parts of the Dodd-Frank financial regulations. The bills will now proceed to a floor vote.
So what do these measures do? They weaken Title VII of Dodd-Frank, which is the part that regulates derivatives. Since Dodd-Frank, there’s been an extensive amount of debate about the new rules for derivatives, which range from collateral to price transparency. But there has also been a counter-debate about who has to follow the new rules. Those who fall under “end-user exemptions” are largely able to forgo following the Dodd-Frank rules, and the easiest way to understand the bills passed out of the Agriculture Committee is to note that they seek to expand the scope of those exemptions.
One bill would weaken cross-border regulations, allowing U.S. firms that run their derivatives in other countries to avoid following the new derivative rules. In the age of electronic trading and overlapping jurisdictions, this limits the ability of regulators to make sure that prudential standards are set in this country. Another would exempt inter-affiliate swaps, or derivatives between various corporate entities, from having to follow the new Dodd-Frank derivative rules (even though the CFTC has already exempted many of these types of swaps, using careful methods that the bank regulators have employed successfully for years).
Another bill exempts public utilities, and those interacting with public utilities, from having to abide by the new derivative rules. Yet another removes much of Section 716, which requires federally supported banks to run their derivatives portfolios in separate corporations without guarantees, as many already do.
So why might one support these bills? The first reason would be if Dodd-Frank was finalized and, over time, it became clear the new rules weren’t necessary. But Dodd-Frank isn’t finalized. We have not yet seen whether these parts of the law go too far -- or not far enough.
(Note that almost all of the bills under question aren’t “technical amendments,” designed to help give guidance or clarity to regulators on the law's intent as they write rules. The one bill that is a genuine technical amendment, the Swap Data Repository and Clearinghouse Indemnification Correction Act, isn’t opposed by financial reform groups.)
A second reason you might support the bills is if these were small, inconsequential parts of the financial industry. They’re not. As Marcus Stanley of Americans for Financial Reform told me: “The major Wall Street banks have literally thousands of subsidiaries in dozens of countries, so proper inter-affiliate regulation is crucial. If cross-border derivatives rules are weakened, you will have regulatory races to the bottom. If both these bills pass, it’s worse than the individual parts, as financial firms are expert at moving money and will use both to effectively evade regulations.”
A third reason is if it were clear that the regulations under question were obviously overkill. But these rules are, as of now, well within the bounds of an appropriate, common-sense regulatory response to the financial crisis. As Wallace Turbeville of Demos, who also testified on the bills, noted, “These bills undercut and second-guess careful work performed by regulators in making rules for the derivatives markets. Congress should not be advancing broad and sweeping statutory exemptions that overturn the judgment of expert regulators and effectively deregulate portions of the derivatives market only a few years after the decision to regulate them for the first time and before the carefully constructed regulatory regime can be evaluated.”
The fourth and final reason to support these bills is if it were clear that the financial sector had learned its lesson from derivatives in the crisis and was showing movement in the direction of being able to regulate itself. Sadly, the opposite is true. As the recent report by Sen. Carl Levin’s subcommittee on investigations found, JPMorgan’s "Whale Trade" derivative losses were not only huge but happened very quickly and were hidden from regulators for a significant amount of time.
Normally you shouldn’t care if a business loses money, which is just part of a market economy, but one of the core tactics for ending Too Big To Fail is using a new resolution authority to kill off large financial firms in danger of collapsing. Early detection of losses is essential for the process, which involves numerous techniques to ease a firm back to solvency or into failure. Firms that are able to hide that information from regulators by using complex derivatives are a big problem for ending Too Big To Fail.
A year ago, then-Treasury Secretary Tim Geithner put out a statement saying that a number of House bills amending derivatives reform while the rules were still being considered were “at best premature” and would likely ”undermine the integrity of the rulemaking process, further complicate the work of the regulators, and increase uncertainty for forms.” It is unclear whether his successor, Jacob Lew, will put energy into opposing these specific bills by name as they go forward with some Democratic support.
It is clear, however, that these rules are a bad idea, especially when financial reform is still being implemented. Lawmakers should realize that they would be dismantling important parts of the bill, rather than tinkering along the edges, if these proceed.