Should Banks Be Banned From Trading Derivatives? The much-maligned financial products brought down AIG and fueled the mortgage market meltdown. But some say they're not all evil -- they reduce costs and provide protection for customers. And as long as trades are done in the open, they say, banks shouldn't be prohibited from the business.
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Should Banks Be Banned From Trading Derivatives?

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Should Banks Be Banned From Trading Derivatives?

Should Banks Be Banned From Trading Derivatives?

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Congress is working on a sweeping financial overhaul bill, and the banking industry wants to make sure it can hang on to the very profitable business of trading in derivatives. Those now infamous financial products helped fuel the mortgage meltdown.

But as NPR's John Ydstie reports, it's not just bankers who are arguing in favor of the derivatives business.

JOHN YDSTIE: Last year, U.S. banks made over $20 billion trading derivatives. But language in the overhaul bill being debated in the Senate could force them out of the business.

Arkansas Senator Blanche Lincoln, a Democrat, is one of the provision's biggest supporters.

BLANCHE LINCOLN: In my view, banks were never intended to perform these activities, which have been the single largest factor to these institutions growing so large that taxpayers had no choice but to bail them out in order to prevent total economic ruin.

YDSTIE: Lincoln's provision would ban banks eligible for government backing, like loans from the Fed or deposit insurance, from trading derivatives. But a top bank regulator, Sheila Bair, who heads Federal Deposit Insurance Corporation, thinks that's a bad idea.

SHEILA BAIR: This idea that somehow now banks can't be doing derivatives, even hedging, is really not a good idea. Derivatives are not all evil.

YDSTIE: In fact, trading derivatives is a core function of banks, says Bair. She argues that moving derivatives trading out of banks, which are highly regulated, could push the business into less regulated markets.

But what are derivatives, exactly? Senator Christopher Dodd, who chairs the Senate Banking Committee, offers this definition...

CHRISTOPHER DODD: Really what it amounts to in simple terms that most Americans can understand is it's a bet. It's a wager.

YDSTIE: Cory Strupp, a lobbyist for the Securities Industry and Financial Markets Association, disagrees.

CORY STRUPP: I don't think it's fair to characterize this as bets any more than when a bank makes a loan they're making a bet that maybe some day they'll get paid back.

YDSTIE: Strupp says banks use derivatives to reduce their risk and the risks of their customers.

For instance, a bank might have a customer, let's say a homebuilder, who wants some protection from a rise in interest rates. So the bank sells the homebuilder a derivative called an interest rate swap. The bank is then on the hook to pay the homebuilder if interest rates go up.

But the bank may not want to run that risk either. So it could create another swap for a different customer who would be hurt if interest rates fall. The two swaps cancel out the bank's risks.

Robert Litan, a financial expert at the Kauffman Foundation, says derivatives reduce costs and provide protection for a wide range of businesses.

ROBERT LITAN: They allow a lot more commerce to take place than would otherwise exist. And so they're sort of one of these invisible ingredients that we take for granted and sometimes exaggerate the dangers of. But we need derivatives, but we also need rules to make them safe.

YDSTIE: Martin Mayer, a guest scholar at the Brookings Institution, agrees, but warns that banks can also abuse their role as derivatives traders.

MARTIN MAYER: There's nothing intrinsically evil about banks doing this sort of work. What is intrinsically evil is for them to be saying to people, you are my client, I have your interests at heart, I am going to organize this in your benefit, and then designing instruments through which your customers are screwed.

YDSTIE: That's essentially what Goldman Sachs has been accused of doing.

Mayer warned of the dangers of derivatives more than a decade ago. He doesn't think banks should be prohibited from trading them, but if they do, he says, they need to be required to trade in the open on public exchanges, not in the private over-the-counter market.

MAYER: It's the hidden nature of this over-the-counter market that is really disturbing.

YDSTIE: Most derivatives trading would be forced into open clearinghouses and exchanges by the financial overhaul bill being debated in the Senate. Banks are lobbying hard to convince lawmakers that under those conditions they can safely remain in the derivatives business.

John Ydstie, NPR News, Washington.

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