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The Importance of Derivatives for Hedging Risk in Banks of All Sizes

Among the amendments to the “Restoring American Financial Stability Act” (S. 3217) that Senators will consider in the coming days is a provision – agreed to by Banking Committee Chairman Chris Dodd (D-CT) and Agriculture Committee Chairwoman Blanche Lincoln (D-AR) – which would require bank holding companies to transfer their derivatives operations out of the banking subsidiary, or potentially out of the consolidated holding company entirely.  This proposal is misguided for a number of important reasons.

Banks use derivatives to hedge against a wide range of risks to their operations and earnings, including interest rate risk, market risk, foreign exchange risk, and counterparty risk.  As FDIC Chairman Sheila Bair wrote in an April 30th letter to Senators Dodd and Lincoln: “The vast majority of banks that use OTC derivatives confine their activity to hedging interest rate risk with straightforward interest rate derivatives…Derivatives such as customized interest rate swaps and even some CDS do have legitimate and important functions as risk management tools.”  Legislation that would prohibit banks from availing themselves of these valuable risk management tools, Chairman Bair wrote, would lead to “weakened, not strengthened, protection of the insured bank.”

Also, Treasury Secretary Timothy Geithner recently commented that, “You would not make the system more stable by taking functions that are integral and central to banking and separating and putting them somewhere else.  That will create a less stable system…and that basic strategy underpins the entire approach…to this important set of reforms.”

Moreover, insured banks are the most highly regulated of all financial entities.  Requiring bank holding companies to divest of their derivatives businesses would force the derivatives-related activities into “less regulated and more highly leveraged venues,” Bair wrote.  An analysis produced by Federal Reserve staff similarly concluded that the provision would “impair financial stability.”

Removing a bank’s ability to hedge risk would also apply upward pressure on the cost of many financial products and services that banks provide.  For example, banks that underwrite traditional residential mortgage loans are exposed to a number of interest rate risks.  During the application process, for example, the rate is usually locked, exposing the bank to losses if interest rates rise.  Similarly, after closing and during the servicing stage of the loan, a drop in rates can lead to refinancing, which lowers the value of the bank’s mortgage servicing assets.  Finally, as market interest rates fluctuate over the three-decade life of the loan, the bank’s hold-for-investment portfolio will experience rate–related changes in its value.  Banks hedge each of these risks through derivative contracts known as interest rate swaps and other transactions.  If banks are unable to effectively hedge these risks, offering basic services will become more expensive, thus driving up costs to homebuyers.

Effective, sensible financial regulatory reform that will ensure a safer, more sound, and more stable financial system must be achieved this year.  But as Chairman Bair, Secretary Geithner, Comptroller of the Currency John Dugan, and Federal Reserve staff have all pointed out, forcing banks to spin off their derivatives operations is ill-conceived, misguided, and at odds with the basic objectives of financial reform.

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The Financial Services Forum is a non-partisan financial and economic policy organization comprising the CEOs of 18 of the largest and most diversified financial services institutions doing business in the United States.

The purpose of the Forum is to pursue policies that encourage savings and investment, promote an open and competitive global marketplace, and ensure the opportunity of people everywhere to participate fully and productively in the 21st-century global economy.

Welcome to ForumBlog. This is where our policy team analyzes the latest proposals, ideas, and news surrounding financial sector regulatory reform, trade, and the economy. Our goal is to provide thoughtful insights on the issues impacting the intersection of Wall Street and Washington, as we pursue policies that encourage savings and investment, promote an open and competitive global marketplace, and ensure the opportunity of people everywhere to participate fully and productively in the 21st-century global economy.