Fed weighs foreign banks derivatives deal

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The US Federal Reserve is weighing a plan that would allow big foreign banks to avoid costly regulatory changes that were meant to prevent derivatives trading from being subsidised by US taxpayers.

The changes arise from a measure known in the financial industry as the Lincoln amendment, named for Blanche Lincoln, former US senator. It was included in the 2010 overhaul of US regulation known as Dodd-Frank.

Her amendment in effect prohibits banks that have access to US government-provided deposit insurance or Fed credit facilities from acting as derivatives dealers, on the basis that the taxpayer-provided safety net may subsidise such activities. There are some exceptions.

However, when the provision was drafted, lawmakers did not extend the exceptions to US branches of foreign banks that do not have access to deposit insurance. Most foreign banks’ US branches lack it.

Though US financial groups will continue to be allowed to trade instruments such as interest rate swaps out of their banks, foreign banks’ US branches will be forced to move all of their derivatives activities to affiliates outside the bank.

Funding costs are typically lower for banks than non-bank affiliates inside financial groups known as bank holding companies. The provision is expected to increase the cost of capital for foreign groups. Financial industry representatives have argued that the measure, if adopted, would make it more difficult for regulators to resolve failing financial institutions.

As foreign banks have grown increasingly concerned about the derivatives measure, the Fed has begun to consider treating foreign banks’ US branches as separate legal entities, according to people familiar with the matter.

The “separate entity doctrine” would call for the Fed to treat different branches of the same foreign banking group as distinct legal entities for the purposes of US regulations. For example, one branch of a foreign group could continue to enjoy access to the Fed’s discount window for emergency funding while another of its branches acts as a swap dealer.

The Fed’s bank supervision and legal departments have discussed the potential strategy, people familiar with the matter said. The Fed has also reached out to foreign groups that would be affected by the rule.

Leading financial institutions including Société Générale, Deutsche Bank and Barclays are among the groups that have met with regulators about the so-called “swaps push-out” rule. Government officials from Mexico and Japan have also talked with US financial regulators.

The separate entity proposal was detailed in a joint white paper written by lawyers at Davis Polk, Cleary Gottlieb Steen & Hamilton, and Sullivan & Cromwell. It was shared with the Fed last July. The measure is set to take effect in July.

Lawyers at Davis Polk & Wardwell said in a client note this week that there is “significant uncertainty” regarding the rule’s impact on foreign banks.

US regulators had opposed the measure when it was before Congress. On the day Dodd-Frank was passed by Congress, Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a “significant oversight” that was “unfortunate and clearly unintended”.

But because the language of the legislation is clear, regulators are unable to use her statements on the Senate floor to unilaterally change the implementation of the law.

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