Banks fight to exempt half of swap books from transparency

A Bloomberg article reported on how large US banks are lobbying to exempt their swap books from Dodd-Frank Act capital and margin requirements as well as transparency.

Using a classic lobbying strategy, Wall Street's Opacity Protection Team is making the level playing field argument and saying that they would be at a competitive disadvantage if their Edge Act foreign subsidiaries were subject to capital and margin requirements as well as transparency.

The regulators response should be that the regulators are setting the 'gold standard' and they expect every other country to modify their regulations to meet it as oppose to US regulators adopting existing regulations from other countries that have been shown to be inadequate.

This lobbying also highlights the extremes that Wall Street's Opacity Protection Team will go to head off transparency.

Specifically, the Opacity Protection Team is arguing that US regulators don't need to see the banks' swap books held offshore, but can instead rely on the foreign regulators to review these books.

While I don't think that macro-prudential regulators are going to be successful, at a minimum, they need to have access to all the useful, relevant information for each bank.  Not having access to information on half of each bank's swap book would directly undermine the macro-prudential regulators.

Regular readers know that I would throw away most of the Dodd-Frank Act and substitute ultra transparency instead.  At the end of the day, ultra transparency requires far less regulation to mandate and it produces far better regulatory outcomes.

More than half of the derivatives- trading business of Goldman Sachs Group Inc. (GS), Morgan Stanley and three other large banks could fall largely outside the Dodd- Frank Act if they succeed in lobbying regulators to exempt their overseas operations, government records show....

Banking lobbyists have been gaining traction with their argument that a combination of U.S. supervision of their holding companies and foreign supervision of their operations abroad is sufficient to oversee risk to the financial system. 

While the banks haven’t publicized how much of their swaps business is overseas, they file quarterly statements to the Federal Reserve. A Bloomberg News analysis of the filings shows that Goldman Sachs had 62 percent of its $134 billion in fair- value derivatives assets and liabilities in non-U.S. branches or subsidiaries for international banking as of Sept. 30, while 77 percent of Morgan Stanley (MS)’s $101 billion was in non-U.S. operations. 

If overseas operations aren’t subject to U.S. rules or equivalent regulation by other nations, it could impede the goal of preventing another credit crisis, Darrell Duffie, professor at Stanford University’s Graduate School of Business, said in a telephone interview. 

“Not only is that neglectful from a viewpoint of systemic risk as it sits today, but it’s also an incitement to move the risk abroad,” Duffie said.... 

The provision raised the stakes for banks because their swaps business is global. In 2008, Sally Davies, a Fed adviser, said that between 55 percent and 75 percent of U.S. banks’ notional derivatives exposure was with non-U.S. residents.

For example, New York-based Goldman Sachs’s largest counterparty for credit derivatives on the eve of the credit crisis in June 2008 was Deutsche Bank AG (DB)’s London branch; its third-largest interest-rate derivatives counterparty was JPMorgan’s London branch; and its largest counterparty for currency products was Royal Bank of Scotland Plc’s London branch, according to a 2010 report from the Financial Crisis Inquiry Commission, a U.S. panel that investigated the crisis. 

Selling over-the-counter derivatives is among the most lucrative business for financial companies, with U.S. bank holding companies reporting $14 billion in trading revenue in the third quarter of 2011, according to the OCC. The five banks control 95 percent of cash and derivatives trading for U.S. bank holding companies, which had $326 trillion in notional derivatives as of Sept. 30, the agency said....

Derivatives, including swaps, are financial contracts tied to interest rates, commodities or events, such as the default of a company. The values of overseas derivatives held by individual banks that were calculated for this story include assets and liabilities for foreign branches and subsidiaries, including so- called Edge corporations. 

Edge corporations, formed under the 1919 Edge Act on international banking, are bank subsidiaries for which Congress granted greater leeway to compete overseas. Citibank Overseas Investment Corp., J.P.Morgan International Finance Limited and Bankamerica International Financial Corp. are among Edge subsidiaries that have interest rate and equity derivatives and could benefit from an exemption.

The banks don’t report the holdings of Edge corporations in their standard quarterly filings. 

According to documents obtained through a public records request to the Fed, Citibank’s Edge corporation had a combined $7.8 billion in fair-value derivatives as trading assets and liabilities in the first quarter of 2011, while JPMorgan’s had $88 billion. 

Banks are seeking to have Edge corporations and other international affiliates exempted from Dodd-Frank rules when they have contracts with non-U.S. companies, Sullivan & Cromwell said in a letter on June 29. The exemption should also cover the subsidiaries’ swaps with foreign-based affiliates of other U.S. companies because the trades don’t have a direct and significant effect on U.S. commerce, the law firm said in its letter. Under the requested exemption, two U.S. companies could trade swaps outside of Dodd-Frank rules so long as their overseas affiliates engaged in the transaction. 

The combination of U.S. banking supervision at the parent company level and foreign regulation of overseas operations is sufficient to protect the U.S. financial system, according to the Sullivan & Cromwell lawyers.

U.S. and European Union regulators have said they want to bridge international gaps to avoid disparities that helped undermine oversight of American International Group Inc. (AIG) in 2007 and 2008 and contributed to a $180 billion taxpayer bailout. The insurer booked many of its swaps in Europe, where regulators in 2007 decided that U.S. authorities should have oversight. That transatlantic split “excluded any comprehensive examination and regulation” of AIG’s credit-default swaps, the U.S. Congressional Oversight Panel said in a June 2010 report.