Swaps spin-off proposals look costly for banks

NEW YORK/WASHINGTON (Reuters) - A proposal to rein in derivatives trading could translate to billions of dollars of lost annual revenue for banks including JPMorgan Chase & Co JPM.N and Goldman Sachs Group GS.N.

Senate Agriculture Chairman Blanche Lincoln is expected to unveil a financial reform bill on Friday that would prevent banks with deposit insurance from also trading derivatives known as swaps.

Banks would have to find a way to separate their swaps trading operations from the rest of their business, although the mechanism for doing so is not spelled out. Under Lincoln’s plan, over-the-counter derivatives -- those with common terms and wide sales -- would move onto regulated exchanges in many cases.

Globally, the $450 trillion over-the-counter derivatives market is big business for the banks. Scaling back these operations, or forcing high-volume contracts to move to exchanges, could make trading much less profitable for dealers. Customized contracts would continue but face higher costs.

Lawmakers have sought ways to rein in the opaque world of over-the-counter derivatives after the financial instruments were blamed for exacerbating the financial crisis and prompting the U.S. government bailout of companies such as American International Group AIG.N.

Jamie Dimon, chief executive of JPMorgan Chase & Co JPM.N, told bank analysts on Wednesday that forcing dealers to trade derivatives on exchanges could cost his firm up to a couple of billion dollars in revenue annually.

“It will be a negative,” he said. JPMorgan has the largest derivatives exposure of the U.S. banks.

Just five banks account for 97 percent of the total $212.8 trillion worth of derivatives contracts held by U.S. commercial banks, according to a fourth-quarter survey by the Office of the Comptroller of the Currency.

Lincoln’s effort will join proposals already on the table from the Obama administration and Senate Banking Committee chairman Chris Dodd and is be the most aggressive package.

Her proposal would prohibit any bailout of dealers, buyers or “swap entities.” Derivatives like swaps take their value from underlying assets such as bonds, currencies or commodities, or can be tied to changes in interest rates.

But it is unclear how big banks like JPMorgan would shed their “swap entities.” These companies could not likely exist as standalone entities, because they would lack both the funds and the trust to buy and sell swaps.

“Today, because of credit concerns, you would find it very hard to unbundle this market,” said Christopher Whalen, co-founder of Institutional Risk Analytics.

If banks shed their swaps desks, they would essentially be getting out of the trading business, and focusing on areas like lending, said Kevin McPartland, senior analyst at research firm TABB Group.

“This is a back-door way to reinstate Glass-Steagall without actually doing so,” McPartland said.

“For the swap desk to be successful and continue providing the service they do, it’s important that they have bank capital behind them,” McPartland added.

JPMorgan, Bank of America BAC.N, Goldman, Morgan Stanley MS.N and Citigroup C.N had the largest derivative exposures of all holding companies in the fourth quarter at $78.66 trillion, $72.53 trillion, $48.85 trillion, $41.51 trillion and $39.35 trillion, respectively, according to the OCC survey.


But Lincoln’s proposals still have to withstand hearings, lobbying, and Republican opposition before becoming law.

Some Senate staff workers believe banks enjoy the cushion of Federal Reserve backing that other market participants do not have, a potentially unfair advantage.

If approved by the Agriculture Committee, the package would be wrapped into an omnibus regulatory reform bill approved by the Banking Committee and awaiting Senate debate.

Treasury Secretary Timothy Geithner praised Lincoln’s plan. “Based on what she’s laid out in public it looks like a very strong bill,” he said at the White House on Wednesday.

Lawmakers are under pressure to address voters’ outcry over the billions of taxpayer dollars spent to prop up financial institutions during the crisis.

“There’s a kind of ill-defined feeling on the part of both parties that they have to do something, because when they go home people yell at them,” said Whalen.

Lincoln’s proposals, as outlined by committee staff, are the most aggressive on the table, according to McPartland, and that could make it less likely for them to survive to the final legislation.

“We don’t need to kill the existing model, we just need to figure out how to have better oversight and reduce systemic risk,” McPartland said.

Reporting by Elinor Comlay and Charles Abbott, editing by Leslie Gevirtz