NEW YORK A proposal designed to insulate banks from bad derivatives trades could reshape the way the contracts are traded in the United States, making foreign banks more powerful and helping start-ups win market share.
The losers could be the biggest U.S. derivatives dealers, including JPMorgan Chase & Co, Bank of America Corp, Goldman Sachs Group Inc, Morgan Stanley, and Citigroup, which together account for more than 95 percent of outstanding derivatives contracts among U.S. banks.
The specifics of the new law are still being worked out, but lawmakers are discussing the possibility of forcing banks to move any derivatives trading business that they do for customers into a separate subsidiary of the bank's parent company.
The subsidiary would need its own capital, and if it ran into trouble, the bank with which it was affiliated could not legally bail it out -- although the Federal Reserve could if the unit were systemically important.
U.S. Senator Blanche Lincoln has floated the language as a compromise to an amendment to a broader financial reform law she championed that many believed would have forced banks to get out of the swaps business altogether.
The revised plan would let banks continue to use derivatives like swaps to reduce their risk. But if a bank made bad trades on its dealing desk with customers, only a small part of the overall banking company would collapse.
Segregating the derivatives business would also help regulators insure that banks were holding enough capital against their trades to avoid situations like American International Group Inc's. AIG required a massive government bailout after taking excessive credit derivatives risk that regulators were not watching.
"It means doing an entirely different kinds of swaps business," said Michael Greenberger, professor at the University of Maryland School of Law and former director of the division of trading and markets at the U.S. Commodity Futures Trading Commission.
Many traders and analysts on Wall Street question how effective the provision will be.
But the broader financial reform bill could have a big impact on profits for the biggest banks.
Citigroup analysts led by Keith Horowitz estimated in a report on Wednesday that Goldman Sachs' earnings per share could be hit by as much as 23 percent, Morgan Stanley's by 20 percent, JPMorgan's by 18 percent, and Bank of America's by 16 percent.
KIDS MAKING LESS MONEY
There are some real difficulties associated with banks setting up separate units to house their derivatives, traders and executives noted. Banks often tie derivatives to other products -- for example if a company wants to issue bonds, it might also want to use derivatives to change the interest it pays on the debt from a long-term rate to a short-term rate.
If the derivative business were housed in a separate subsidiary with different management, the process of bundling derivatives with other products might be more cumbersome and therefore less likely to happen.
Derivatives subsidiaries might need more capital on their own than they would as part of a larger bank, because they would not have other business lines to support them, although if far more trades were happening on exchanges, capital demands might not be that significant.
More onerous for the subsidiaries might be the matter of funding. The units would need to find a way to fund themselves for posting collateral on trades, which could require them to borrow money on their own.
Funding and capital could increase U.S. banks' cost of doing business, which in turn would decrease profits for banks and force them to quote less competitive prices.
If foreign banks could offer better pricing and more integrated products, they could have a real advantage over their U.S. counterparts.
And start-ups might benefit, too, because they could raise capital and be just as strong as JPMorgan Chase & Co's derivatives unit. Hedge fund Citadel has been ramping up its broker/dealer operation, an effort that could gain new steam. Smaller broker dealers might also be able to attract more capital to compete against the big players.
These extra costs don't have to be fatal for big U.S. derivatives businesses, experts said.
"It will probably have a marginal impact. The kids on the derivatives desks will make less money, and they'll be less competitive. But these are very bright people, and they will find ways to make money in these markets," said Steve Kohlhagen, who ran derivatives businesses at First Union and later Wachovia.
One Wall Street lawyer noted that banks might try to use contracts whose legal form differs from standard derivatives, such as insurance contracts, to get around the law.
And if the new structure made banks safer, then losing some business to foreign banks and new entrants might be an acceptable cost.
But many industry watchers question whether these new subsidiaries would make banks safer. Generally, when one unit of a bank fails, investors lose faith in the entire company, whatever the legal structure.
"There's this little thing called confidence. Typically, when a company is going down, investors don't discriminate among different subsidiaries -- they just run in the other direction," said Tanya Azarchs, a senior bank analyst at Standard & Poor's in New York.
The logic of the Volcker rule -- a part of the financial reform law which would restrict banks' ability to trade for their own accounts -- is much easier for Wall Street professionals to understand.
One thing for sure: lobbyists will be fighting this provision every step of the way. Should it make it into law, it might not be implemented for two years, by which time a new Congress would have had ample opportunity to water it down or kill it entirely.
But at this stage, few legislators and regulators want to be seen as soft on financial reform, which means the rule really could end up seeing the light of day.
U.S. Senator Christopher Dodd, Dallas Federal Reserve Bank President Richard Fisher, Kansas City Fed President Thomas Hoenig and others have expressed support for the Lincoln amendment.
(Editing by Gerald E. McCormick)