A proposal gaining ground on Capitol Hill to force banks to spin off their derivatives-trading operations would represent a severe blow to one of Wall Street’s most profitable businesses.
Passage would represent a particular setback for J.P. Morgan Chase & Co. (JPM), which ranks as the nation’s largest derivatives player, with a notional amount of derivatives contract of over $78 trillion according to data from the Office of the Comptroller of the Currency.
J.P. Morgan Chief Executive James Dimon said he supports a proposal to send standard derivatives contracts through an industrywide clearinghouse that can be monitored by regulators. He has opposed a requirement that all trades be moved onto an exchange, in part because it would inhibit the use of customized instruments.
Bankers scrambled Monday to learn more about the spinoff proposal, which gained momentum this weekend when Senate Democrats folded the derivatives plan into their broader financial-overhaul package.
Derivatives dealers need to hold a large chunk of capital, because clients want to be sure that dealers will be able to fulfill their obligations. Companies that purchase derivatives, ranging from airlines to farmers to oil producers, often strike multibillion-dollar contracts with dealer banks.
By breaking off derivatives operations from the banks, legislators hope to reduce the risk a meltdown in that market would threaten depositors and require a federal bailout.
Several Wall Street firms and industry experts maintain the proposal would do little to reduce risky behavior, while making the U.S. banking industry less efficient.
Without their derivatives business, “the big banks will contribute less systemic risk, so it may be better for the taxpayer,” said Morningstar analyst Matthew Warren.
Requiring spinoffs, they say, would throw derivatives trading into the hands of foreign institutions and lightly regulated hedge funds. They also said the new rules could force dealers to put up more capital, which could take capital away from lending to consumers and businesses.
Besides big banks, “who’s going to have the balance sheet to support these positions?” said Howard Simons, a strategist at Bianco Research. “You need someone who has the balance sheet.”
The Federal Reserve over the weekend tried to kill the provision, telling lawmakers in a letter that section of the overhaul bill “should be deleted.”
Paul Miller, an analyst at FBR Capital Markets, said he was swamped Monday with questions from clients who wanted to know more about the proposal. Mr. Miller estimates that banks could lose anywhere between 2% to 5% of their return on equity from the proposal, though he also acknowledges that “if Washington takes this away from the banks, [the bankers] are sure going to work very hard to find something else” to make up the lost revenue.
Critics have blamed derivatives as a culprit in the credit crisis, saying the lightly regulated and opaque markets froze up when traders feared some firms wouldn’t be able to make good on their promises.
The derivatives legislation would boost federal oversight and transparency of the market. The most controversial proposal is the provision to force banks that are eligible for financial assistance from the Federal Reserve and the Federal Deposit Insurance Corp. to spin off their derivatives-trading desks.
If passed, that provision would represent one of the most dramatic shifts in how Wall Street works since the credit crisis struck.
