Obama administration officials, industry groups, banking regulators and lawmakers from both sides of the aisle have taken aim at the measure proposed by Sen. Blanche Lincoln (D-Ark.), chairman of the Senate agriculture committee.
Their main objection: If a central goal of regulatory overhaul is to make financial markets more transparent and accountable, Lincoln's provision would have the opposite effect. Barring banks from trading in derivatives would force those lucrative business into corners of the market where there's even less oversight, critics warn.
"If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less regulated and more highly leveraged venues," Federal Deposit Insurance Corp. Chairman Sheila C. Bair wrote in a recent letter to lawmakers.
She said that Lincoln's measure could push $294 trillion worth of derivatives deals beyond the reach of regulators. If some FDIC-insured banks simply transferred this type of business to affiliated firms, it could still pose a danger because the affiliates would not be required to set aside as much capital as banks to cover losses from derivatives trading, Bair said.
She added that a possible unintended consequence of the legislation "would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund, which I know is not the result any of us want." She said this danger exists because financial troubles at an affiliate could in times of crisis threaten the bank. Some administration officials share Bair's worry that the provision could undermine the goal of making derivatives trading less opaque.
"You'd rather make sure that it's regulated," said one administration official, who spoke on the condition of anonymity because the matter has not been resolved. "The whole principle of [regulatory] reform is not to push things into dark corners."
Federal Reserve officials expressed their reservations to Lincoln's staff members when they were working with their counterparts from the Senate banking committee to combine legislation passed by each panel. The agriculture and banking committees both have had a traditional interest in derivatives, which originated decades ago with trading in farm products.
In a memo, Fed officials said that forcing banks to separate derivatives trading from banking operations would "impair financial stability and strong prudential regulation of derivatives," "have serious consequences for the competitiveness of U.S. financial institutions" and "be highly disruptive and costly, both for banks and their customers."
Lincoln has stood by her proposal, which has garnered support from consumer advocates, saying she wants to protect bank depositors from risky trading activities. "It ensures banks get back to the business of banking," said Courtney Rowe, Lincoln's spokeswoman.
But other lawmakers have raised concerns.
"As we try to put in place new rules around derivatives, we don't want to push the whole derivatives market offshore," Sen. Mark Warner (D-Va.) said recently on the Senate floor.
Sen. Judd Gregg (R-N.H.) said Monday that Lincoln's measure would not only push derivatives transactions offshore but would constrict credit to Main Street businesses that benefit from the ability to hedge against changes in asset prices.
"This is a real job killer. It would cause contraction in the economy," Gregg said. "It's really a poor idea, and it has no purpose, in my opinion, that's constructive. It's just a punitive exercise aimed at Wall Street."
Amendments aimed at killing the Lincoln provision are likely to emerge as lawmakers begin this week to consider dozens of changes to the financial overhaul bill, according to congressional sources.