FDIC concerned with swaps rules in Democrats' bill

Federal Deposit Insurance Corportation (FDIC) Chairman Sheila Bair speaks at the Reuters Global Financial Regulation Summit in Washington April 27, 2010.

WASHINGTON (Reuters) - A top U.S. banking regulator is concerned with a provision in a bill by Senate Democrats that would require banks to spin off their swaps desks, according to a letter obtained by Reuters on Saturday.

Federal Deposit Insurance Corp Chairwoman Sheila Bair said this could move some of the riskiest parts of banks' business out of the purview of federal oversight.

Her comments come as the regulator of the biggest U.S. banks -- Comptroller of the Currency John Dugan -- said limiting banks participation in the swaps market was not the right policy and could cause capital to leave the lending part of the banks.

Bair voiced her concerns in a letter to the two senators in charge of writing rules for the $450 trillion swaps market, Senate Banking Chairman Christopher Dodd and Senate Agriculture Chairman Blanche Lincoln.

Lawmakers have been trying to shed light on the over-the-counter derivatives market in an attempt to avoid a repeat of the chaos and near collapse of American International Group, which had a hefty swaps portfolio.

Next week, the Senate is expected to start debating and changing the Democrats' bill, which would impose new rules for Wall Street and try to ensure better protections for consumers and investors.

Rules for the over-the-counter derivatives market is one of the most controversial parts of Democrats' legislation and some senators are trying to change the language.

Under the Democrats' bill, banks would be forced to choose between keeping their federal guarantees like deposit insurance, or keeping their derivatives trading desks.

Bair said if all derivatives activities were moved outside of banks, "most of the activity would no doubt continue, but in less regulated and more highly leveraged venues."

"I urge you to carefully consider the underlying premise of this provision -- that the best way to protect the deposit insurance fund is to push higher risk activities into the so-called shadow sector," Bair said in her letter to Dodd and Lincoln, dated April 30.

The bill would also require most swaps to be cleared by clearinghouses, which would assume the risk if one party defaults, and mandatory clearing and trading of most swaps on exchanges or electronic platforms.

Bair said directing standardized derivatives products on exchanges or through clearinghouses would "accomplish the stabilization of the over-the-counter market ... and would still allow banks to continue the important market-making functions that they currently perform.

(Reporting by Rachelle Younglai)