Glitch in Swaps Regs May Penalize Foreign Banks

WASHINGTON — Industry representatives are praising a recent move by regulators to provide more time to comply with pending swap restrictions, but many said the fix highlights a lingering problem with the rules that will effectively penalize foreign banks operating in the U.S.

Under the Dodd-Frank Act, banks must move swaps activities — excluding certain hedging deals — into affiliates without U.S. government support. Regulators had initially set a mid-July effective date, but the Office of the Comptroller of the Currency — as allowed by the financial reform law — said recently it will grant extensions of up to two years. Other regulators are expected to follow suit.

But due to an apparent congressional error, branches of foreign banks that lack deposit insurance are disqualified from the extended phase-in, and must soon move hedging activities that their U.S. counterparts can keep. That has prompted calls either for an accommodation from the Federal Reserve Board, which oversees foreign banks' U.S. activities, or a legislative fix.

"If there were a single technical correction which Congress should deal with, it seems to me it is this one. It is a very harsh and inequitable result, not only with no justification but with no intent," said H. Rodgin Cohen, a partner at Sullivan & Cromwell LLP.

The push-out rule, authored by former Sen. Blanche Lincoln, D-Ark., was meant to move riskier activities outside the safety net. But it faced stark opposition — including from key regulators — over concerns that transferring activities into less-regulated entities would not make the system safer.

"We continue to believe that the underlying swaps push out provision is bad policy, a view shared by" Fed "Chairman [Ben] Bernanke and then-[Federal Deposit Insurance Corp.] Chairman [Sheila] Bair," said Ken Bentsen, executive vice president for the Securities Industry and Financial Markets Association.

"The provision should be corrected by Congress, and we appreciate the OCC's … allowing institutions additional time to comply with the provision, since regulators have yet to propose any rule related to Section 716 implementation, a task further complicated by questions regarding extraterritorial application."

The push-out applies to institutions with deposit insurance, discount-window access, or both. As concessions to the industry, regulators were allowed to consider phase-ins, and certain derivatives used to mitigate risk — such as interest-rate swaps — were exempted for any "insured depository institution."

But some foreign-owned branches taking only wholesale deposits are not insured, and therefore do not qualify for the exemption. And since they utilize the discount window, they face a stricter version of the ban. Although numerous lawmakers from both parties supported legislation last year attempting to correct the oversight, it failed to pass, and Congress essentially has until the middle of July to try again.

"Unless somebody can come up with Plan B or Congress can be persuaded to clean this mess up, it's a real problem," said Karen Shaw Petrou, a managing partner for Federal Financial Analytics Inc.

Even Lincoln herself recognized the error, saying in July 2010 after the provision passed that in lawmakers' "rush to complete" the final reform law, "there was a significant oversight made in finalizing" the amendment "as it relates to the treatment of uninsured U.S. branches and agencies of foreign banks."

"This oversight on our part is unfortunate and clearly unintended," she said.

Both the FDIC and the Fed must issue their own policies about the phase-in period. Under the OCC's decision, federally-chartered banks and thrifts must submit written requests by the end of this month to delay compliance for a period of up to two years. At the end of those two years, Dodd-Frank allows the agencies in subsequent guidance to permit an additional year's time.

"Giving time here recognizes the realities of the situation without creating, I think, any real risk to the banking system," Cohen said.

But observers agree the bigger issue is whether the Fed can use its authority to ease the impact of the push-out on certain foreign-owned branches. Under the current statute, no phase-in period would apply to those branches. Some observers have suggested the central bank may have leeway under a legal theory recognizing separate branches of foreign banks as entirely different legal entities. That theoretically would allow a branch that uses the discount window to move its swaps activities to a branch without access to government-back credit lines.

"The fact that the statute did not extend the exemption to the uninsured branches of foreign banks is an unintended glitch in the drafting," said Randall Guynn, a partner at Davis Polk & Wardwell. "The lawmakers wanted the regulators to fix it, but so far they have been unwilling to say the exemption includes those uninsured branches."

"The question is: How does the Federal Reserve make a suitable accommodation to them to put them on more equal footing with U.S. banks?" Guynn added.

Yet such a legal interpretation may be a stretch considering the definitions outlined by Dodd-Frank.

"I have some sympathy for" the regulators "in view of the literal language of the statute," said Cohen.

Petrou agreed that "the real challenge is the law."

"The Fed has supported legislation to clarify its ability to do so," she said. "There are two issues for uninsured foreign banks. One is whether or not they get the transition. The other more critical issue is whether the exemptions in the law for certain [over-the-counter] derivative activities that can stay in the insured depository would apply to them. They have an even worse problem than the U.S. banks. But the challenge, and it's a legal conundrum, is whether or not the regulators can do much of anything because of the way the law was drafted."