Vanessa Drucker: Thin end of the wedge

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They are partying like it’s 2007, markets are dancing with record highs, and the financial crisis feels distant again.  Or so you might think, judging from a controversial derivatives provision slipped into the American omnibus $1.1trn spending bill, which funds the government through September 2015.

That provision would roll back an arcane element of the Dodd-Frank reform legislation known as the Lincoln Rule, named after Senator Blanche Lincoln. Repealing it will again allow commercial banks to maintain risky exotic derivatives on balance sheets, instead of pushing them out into separately capitalised entities, uncovered by government FDIC insurance.  The consequence is that once again taxpayers could be on the hook for a blow up.  Traders could ”gamble with taxpayer money and get bailed out by the government,” railed Elizabeth Warren, the most vocal senator to protest the deal.

From a public policy standpoint, there is little excuse for reinstituting such leeway.  The provision is a pure gift for a few large banks, particularly Citi, JP Morgan and Bank of America.  Those institutions have lobbied frantically, spending about $5m a year apiece, along with the American Banking Association and the Financial Services Roundtable.  JP Morgan’s Jamie Dimon called lawmakers personally to plead the case.

The industry presents a flimsy rebuttal, arguing that the Dodd-Frank rule makes it less compelling for commercial banks to deal in certain swaps, and encourages them to exit that market. That might shunt those derivatives into less regulated territory, like hedge funds.  A critical point is that Lincoln’s rule has already been watered down once. Vanilla instruments, (such as interest rate swaps, foreign exchange and cleared credit derivatives) already remain at commercial banks, while the revised rule only addresses potentially dicey vehicles, like uncleared CDS, equity and commodity derivatives.

It is disturbing that President Obama and some influential democrats have looked the other way, sacrificing future financial stability for immediate political gain in negotiating and consummating  the spending bill. (They realise government shutdowns cost politicians dearly.) But remember that the 2008 crisis also started out slowly, in incremental steps, as deregulation allowed banks to take on unmanageable risk.