Federal Regulators Have Gutted Safety and Soundness Rules for the Biggest Wall Street Banks

By Pam Martens and Russ Martens: November 12, 2020 ~

Last week, the New York Times’ Emily Flitter, Jeanna Smialek and Stacy Cowley provided an excellent rundown of the dangerous rollbacks of regulations on the big banks by federal regulators appointed by Donald Trump.

Today, in preparation for a hearing with these regulators, the House Financial Services Committee has released a Memorandum that further outlines how the safety and soundness of the biggest banks have been impacted by changes to regulations.

Many of the rollbacks or watering down of the bank rules have occurred quietly or without the attention of mainstream media. Taken together, the rule changes are striking in their reckless disregard for the safety and soundness of a sector that blew itself up just 12 years ago, taking the U.S. economy and U.S. housing market down with it, while getting propped up with the largest taxpayer and Fed bailout in U.S. history.

Today’s House Memorandum contains one paragraph regarding the de-regulation of derivatives (swaps) that should send a shiver down the spine of every American. It reads:

“Swap Margin Rule. The Dodd-Frank Act required most swaps to be cleared, with margin required. Margin is also required for uncleared swaps involving financial institutions whose primary regulator included one of the three banking regulators. Initial margin is the amount of margin posted when the swap is entered into, while variation margin is changes in the amount of margin posted over time to reflect changes in the underlying swap’s value. In June 2020, these regulators issued a final rule modifying the 2015 swap margin rule, exempting uncleared swaps with inter-affiliates from initial margin requirements, while keeping variation margin requirements. Fed Governor Brainard argued that the rule would significantly weaken a key capital requirement for the largest banks.”

The House Financial Services Committee has gotten lost in the high weeds. The issue here should not be about posting margin; the screaming issue is that federal regulators would be insane enough to allow an affiliate within one of the serially-charged Wall Street banks to be acting as a derivative counterparty to another affiliate of the same bank.

The whole purpose of having a counterparty to a derivatives trade is that there is an outside party with the financial wherewithal to make good on that trade.

Making sure that Wall Street banks couldn’t again bring down big financial institutions with derivatives as occurred 2008, is why the financial reform legislation known as Dodd-Frank that was passed by Congress in 2010 required the majority of derivatives to be centrally-cleared by a properly capitalized and approved central clearing facility. This was to be accomplished by 2012. It is now 2020 and this stated legislative intent of Congress has been brazenly ignored by regulators and the big Wall Street banks.

According to the most recent report from the regulator of national banks, the Office of the Comptroller of the currency, this is where things stood as of June 30, 2020:

“In the second quarter of 2020, 40.3 percent of banks’ derivative holdings were centrally cleared…From a market factor perspective, 50.7 percent of interest rate derivative contracts’ notional amounts outstanding were centrally cleared, while very little of the FX derivative market was centrally cleared. The bank-held credit derivative market remained largely uncleared, as 36.0 percent of credit derivative transactions were centrally cleared during the second quarter of 2020.”

Let that sink in for a moment. The most dangerous derivatives – credit derivatives that mainly consist of credit default swaps – are only 36 percent centrally-cleared a decade after the passage of Dodd-Frank.

And it’s not just the Trump administration that is thumbing its nose at the intent of Congress when it comes to derivatives. On March 7, 2016, President Barack Obama held a press conference with all of the federal banking regulators sitting with him around a table. He said this:

“We are moving in the derivatives sector; a huge amount of oversight and regulation and now you have clearinghouses that account for the vast majority of trades taking place so that we know if and when somebody is doing something that they shouldn’t be doing; if they’re over-leveraged in ways that could pose larger dangers to the financial system.”

That statement was completely false. When the OCC released its data on derivatives for the last quarter of 2015, it reported this:

“In the fourth quarter of 2015, 36.9 percent of the derivatives market was centrally cleared.”

To put it another way, the “vast majority” or 63.1 percent of derivatives were still being traded in the dark. The exact opposite of what Obama had stated was, in fact, the reality.

It’s clear that the largest Wall Street banks are back to their old habits again when it comes to gaming derivative rules. According to a May 30 report from European academics Pauline Gandré, Mike Mariathasan, Ouarda Merrouche and Steven Ongena, big Wall Street banks were moving vast amounts of their derivative trades to their foreign subsidiaries to evade regulation by U.S. authorities. The paper is titled: “Regulatory Arbitrage and the G20’s Global Derivatives Market Reform.”

According to the report, Citigroup had gone from no interest rate derivatives at its foreign subsidiaries in the fourth quarter of 2010 to over 60 percent by the fourth quarter of 2015. JPMorgan Chase went from about zero percent to more than 40 percent from the fourth quarter of 2010 to the fourth quarter of 2015. Both Goldman Sachs and Morgan Stanley more than doubled their foreign subsidiary exposure to derivatives during the same time frame.

Bottom line: federal regulators are as clueless today as they were in 2008 when it comes to the level of systemic risk these banks pose to the financial system of the United States. The only way to rein in that risk is to break up these banks and restore the Glass-Steagall Act. That would separate these casinos from the federally-insured, deposit-taking banks.

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