Swaps Rule Repeal Shows that Community Banks Are the 99%

"We are the 99%," goes the familiar slogan of the Occupy Wall Street movement. Community bankers may be surprised to find that they, too, are the 99% in a game that is rigged in favor of large banks. This fact is exemplified by the recent congressional showdown over the gutting of Section 716 of the Dodd-Frank Act, also known as the swaps push-out rule.

Passed with bipartisan support in 2010, the rule forced large banks to move their risky swap activities from insured depository institutions to nonbank affiliates. The change was aimed at ensuring that banks would not enjoy government support (i.e., access to federal deposit insurance and the discount window) for these activities. But despite vociferous opposition from progressives like Sen. Elizabeth Warren, a near-repeal of Section 716 was recently passed as part of the congressional budget bill.

Community bankers who focus on traditional, productive banking would have been unaffected by Section 716. This was not by coincidence, but rather by design. Congress took greats pains to craft the rule in a way that would leave community bankers unaffected in most situations. Indeed, in 2013 the Commodity Futures Trading Commission found that out of all the banks operating in the U.S., only 75 (less than 1%) were swaps dealers subject to the rule.

In short, the swaps push-out rule had nothing to do with community banks—the 99%. It should be of no surprise, then, that banking behemoth Citigroup was behind the swaps push-out amendment, having authored most of its substantive content.

Big banks had been trying to overturn the rule for a while. The House of Representatives actually passed Citigroup's amendment back in October 2013. The Senate prudently refused to pass it. Undeterred, supporters of the provision managed in December 2014 to sneak it into must-pass legislation. The House once again passed the swaps amendment, and the Senate this time was compelled to follow suit in order to avoid a government shutdown. The amendment would have had no chance of passage in the current Senate as a standalone bill. But the big banks were determined to have their way, by hook or by crook.

The swaps push-out amendment is typical of big banks' deregulatory playbook. Large institutions wish to remain free to speculate in the opaque financial instruments that Warren Buffett has rightly called "financial weapons of mass destruction." To achieve this end, they have sought to undo regulations intended to place limits on complex financial products, arguing that deregulation would improve the economy and benefit community banks.

In so arguing, big banks gloss over the fact that in 2008 their financial WMDs ruined the global economy and actually increased the cost of capital for community bankers. Unfortunately, many community banks are complicit in their attempts, exhibiting a financial version of Stockholm syndrome. They have lobbied against regulations even when those regulations mainly affect big banks and leave smaller banks unscathed.

The lobbying barrage against the swaps push-out rule is an example of this pattern. Many smaller banks pushed Congress for a repeal of Section 716 even though the law had no impact on them. Similarly, many community banks have lobbied against the Volcker Rule even though that law, by its own terms, has greatly relaxed compliance and record-keeping requirements for smaller banks. It actually makes community banks more competitive against their larger competitors.

The truth is that the amendment to Section 716 serves as little more than a public subsidy to a handful of big banks. As argued by Cornelius Hurley in BankThink, the gutting of the swaps push-out rule provides big banks with a sizeable subsidy in the form of a "too big to fail" guarantee.

Moreover, the amendment serves as a windfall for big banks by allowing them to avoid swaps clearinghouses. The original Section 716 created incentives for swap dealers to clear synthetic derivatives through clearinghouses, instead of on a bilateral basis. The amendment has upended those incentives. Swap-dealing banks can now avoid the costs of, and protections afforded by, clearinghouses for structured finance swaps, provided that the swaps are used for hedging transactions.

This hedging requirement is cold comfort. Let us recall that JPMorgan Chase attempted to characterize the $6 billion loss it suffered from its uncleared London Whale bets as emanating from "hedges" just a couple of years ago.

Because of the amendment, if a dealer like JPMorgan were to default because of swaps gone bad, the Federal Deposit Insurance Corp. would likely be left holding the bag as the first line of defense rather than a consortium of dealers in a clearinghouse,. Admittedly, FDIC also guarantees clearinghouses. But the likelihood of a multiparty clearinghouse defaulting is far lower than the likelihood of an individual swap dealer defaulting.

Thus, in passing the amendment, Congress has opted for government guarantees instead of private risk mitigation. This is the exact opposite of a free-market solution. The vast majority of structured finance swaps are not cleared, so the nation is now primed for a repeat of the government bailouts seen in 2008.

The amendment also grants swap dealers a third, under-reported subsidy: access to virtually interest-free loans under the Fed's discount window. Hospitals, charities, underwater homeowners, military veterans, aid workers, widows, orphans — none of these worthy parties are normally eligible for interest-free loans from the government. The privilege is afforded only to depository institutions. This reflects a fundamental pact that the country has made with the banking sector: banks should spread capital to the broader economy in exchange for the ability to make money from interest.

Community banks abide by this agreement every day. But the same can hardly be said for bigwig banks that leverage trillions of dollars in free money from the Federal Reserve to line their pockets with lucrative fees from esoteric swap deals. Community bankers continue to serve Main Street. And big banks, thanks to the swaps push-out amendment, can continue to serve themselves.

Akshat Tewary is an attorney practicing in New Jersey, a Financial Industry Regulatory Authority arbitrator and President of Occupy the SEC, a nonprofit advocating for financial reform. His Twitter handle is @akshattewary.