Wednesday, December 24, 2014

Repeal of the “Swaps Push Out” Rule— An Evaluation

[The following post is contributed by Mandar Kagade, who is a Policy Analyst at the Bharti Institute of Public Policy, Indian School of Business]

The United States Congress recently passed the Consolidated and Further Continuing Appropriations Act, 2015 that made headlines for reasons not at all related to appropriations; it was in the news rather for including provisions that repealed the so-called “swaps push-out” rule (“Rule”) introduced in the Dodd-Frank Act, 2010 in the aftermath of the recent financial crisis. Influential members of the pro-Rule lobby include Nobel Prize winning Economist, Dr. Paul Krugman (likening the repeal to “revenge of the wall street” in a recent op-ed) and Senator Elizabeth Warren, formerly a law professor at the Harvard Law School. Understandably, they, including others, have come down heavily on the repeal of the swaps push out mandate. This post attempts to push back against such rhetoric and argues that repealing the swaps push out mandate is likely to lower (not aggravate) systemic risk and moral hazard that the Rule purported to do.

Briefly, the Rule foreclosed “federal assistance”[1] to all insured depositary institutions (“Banks”) that domicile their swap dealing business in the same entity as the Banks. It permits the Banks to have or establish an affiliate “swap entity” to conduct swap dealing business. The Rule “safe harbored” a few specified swap dealing activities - swap dealing for the purposes of hedging and risk mitigation was permitted, as was dealing in some statutorily defined swaps. Finally, the Rule permitted Banks to deal in credit derivative swaps subject to the condition that they be cleared through a central clearing counterparty (to mitigate the counterparty risk that swap counterparties are exposed to).[2] On the other hand, the Rule excluded Banks from dealing in structured finance swaps (having asset backed securities as the underlying for example) and other non-structured finance swaps that were outside the purview of the relevant safe harbor statute. The purpose of the Rule was to “ring fence” the speculative activities of the Bank from the more traditional maturity transformational intermediation that Banks performed so that excessive risks from the speculative activities have no spillovers to the broader economy through the Banks. This is further to ensure that the speculative activities of the Banks do not benefit from the implicit capital subsidy that Banks enjoy by being part of the federal deposit insurance system (supervised by the Federal Deposit Insurance Corporation, FDIC).[3]

Before proceeding further, a word about the repeal provision is in order: The repeal provision adds to the exemptions already described above, and permits the Bank to conduct all non-structured and structured finance swap activities, provided they are, a) for hedging or risk mitigation purposes, or b) the securities (that are the underlying of such swap activities) are approved jointly by the relevant prudential regulators in terms if the type and the credit quality.[4]

As pointed out above, there was a strong push back and shrill rhetoric arguing against the repeal. The fact that the banking lobby included the amendment in the unrelated law on federal spending was seen as the powerful “Wall Street lobby” arm-twisting the Main Street to get its way. Media reports about certain lobbyists having actually drafted the repeal provisions augmented the view and proved to be a public relations nightmare for Wall Street generally.

The politics of the repeal however only reflect the political economy of financial regulation in the United States. Every time a financial crisis precipitates, lobbying groups and the politicians advocating greater regulation use the opportunity to impose extensive regulation—mostly without adequate cost-benefit analyses. The popular outrage that marks every expose provides the perfect opportunity to risk monger for political and “turf-enhancement” purposes. The Dodd-Frank Act, so also the Sarbanes Oxley Act (that was passed in the aftermath of the Enron scandal) are testimony to this fact.[5] So, it appears to be a case of double standards to protest when the opposing lobbying groups succeed in moderating some extreme regulations down the road. 

Politics apart however, criticism of the repeal appears overstated for the following reasons:

- Contrary to the belief, pushing out swap dealing to affiliate swap entities is likely to increase systemic risk, not decrease it. This is because of the fragmented nature of the United States financial architecture. Under the Rule, Commodity based swaps would be within the domain of the Commodity and Futures Trading Commission (“CFTC”), and the Securities & Exchange Commission (“SEC”) had the jurisdiction to regulate security-based swaps. Banks were permitted to retain a “Swaps Entity” as affiliate, but such affiliate was mandated to comply with the requirements of either the CFTC or the SEC as appropriate in addition to the Federal Reserve. Multiple regulators having jurisdiction over the same/similar financial product can lead to regulatory arbitrage and let the risk aggregate in the system through instruments that have laxer regulator. On the other hand, the Federal Reserve is the sole regulator (backed up by the FDIC intervention in zone of insolvency) if Banks conduct swap dealing activities on their own balance sheet and as such no such regulatory  arbitrage issues exist with respect to its supervision of the Banks’ swap dealing activities. Further, since the swap activities expose participants to counterparty risks, prudential regulator like the Federal Reserve that have access to the entire balance sheet of the Bank appear to be arguably better suited to regulate the swap dealing activities.

- Finally, since the Rule nonetheless permitted the Swaps Entity to be an affiliate of Banks, it failed to isolate the Bank from the systemic risk component that the Swaps Entity was exposed to while at the same time, making the source of that risk to the Bank one step removed from its prudential risk regulators.  In a nutshell, the swaps push out rule had dubious benefits at best.

- On the other side, capitalizing an entity separately and transferring the technology there entails costs and smaller/regional banks potentially would not incur the expense of doing so; as such, their local clientele will be constrained to purchase hedging instruments from third parties at higher cost than hitherto. Overall therefore, the swaps push out rule would have made risk management costlier. Further, as Patrick Bolton has argued, there are economies of scale and scope in retaining both the traditional lending and fee-based services (like swaps) in the same entity that the Banks lose out on, by divorcing the two. For example, Banks may use the information they obtained through lending to also offer swaps to a trader-borrower that wants to hedge its commodity exposure for example. Note that these economies of scale also enable Banks to pass on the savings to their customers such that the latter are able to hedge their exposure at a much lower cost. The society as such would have lost out on such gains under the swaps-push-out framework. 

- A review of testimonies of the then Chairman, Ben Bernanke and FDIC Chair, Ms. Sheila Bair reveals that both of them had reservations about the Rule. Ben Bernanke pointed out that other provisions mandating settlement of OTC derivatives through a central counterparty, higher margin requirements and enhanced disclosures are better means to mitigate the build-up of systemic risks in the system.  In her testimony, Sheila Bair had pointed out that pushing out swaps activity to an affiliate will weaken the amount and quality of capital that will be held against the activity as a prudential measure and put the swap dealing activity beyond the regulatory supervision of the FDIC.

To summarize, repealing the swaps push out mandate appears to be a move that will decrease systemic risk than increase it and thus beneficial to the society rather than the opposite.  It will enable Banks to serve the risk management needs of their constituents at the same time as enabling the prudential regulators to supervise and monitor them and prescribe optimum provisioning requirements against their swap activities, based on their respective exposures.

Finally, the Congress has delegated the authority to determine the type and credit quality of the underlying asset backed securities (against which Banks may write swaps) jointly to the prudential federal regulators.[6] It appears that the Big Bank lobby will (again) try and lobby the regulators for making this permissive universe as wide as possible.[7] However, the mandate to “jointly” promulgate the type and the credit quality of the underlying asset backed securities will presumably mitigate the risk of regulatory capture at the agency rule-making phase.

- Mandar Kagade

[1] Defined widely to include all federal assistance including most notably, federal deposit insurance to such Banks as conduct both traditional lending and swap dealing activities in  the same entity.
[2] (bare text of Section 716 that codified the Rule).
[3] Typically, Banks borrow from retail depositors that lend to Banks on demand on term basis and make loans to corporate and investors that invest the funds in long-term illiquid projects/ assets.  This “maturity transformation” exposes Banks to unique risks (asset-liability mismatch) that may cause their failure in the event the demand depositors demand their deposits back at the same time. (“Run on the Bank”).  The federal deposit insurance scheme mitigates the risk that the retail depositors run on the Bank by insuring deposits to the extent of USD 100,000 in one person and in one account. By thus lowering the risk, the federal deposit insurance system lowers the true cost of capital for the Banks and thus enables them to benefit from an implicit capital subsidy. This in turn enables the Banks to carry out their traditional lending operations without worrying too much about the run on the Banks.
[4]  See  (bare text of the amendment provisions, “The Swaps Regulatory Improvement Act”)
[5] See generally, John Coffee, The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Perpetuated and Systemic Risk Perpetuated, available at,
[6] Supra note 4 at p.4
[7] See Usha Rodriguez, The Political Economy and the Regulatory Sine Curve available at, (arguing similarly).

No comments: