DERIVATIVES REFORM: BANK PUSH-OUTS UNDER DODD-FRANK

By Robin Maxwell and Rebecca Wasserman, Linklaters

August 5, 2010

After months of fierce negotiations amongst lawmakers, the Obama administration, and countless industry groups,
Dodd-Frank is unquestionably a maze of compromises, leaving many financial institutions still trying to understand
the law and assess its effect. This is particularly true of the derivatives regulation provisions, which comprise a
substantial portion of the bill and which will have a profound impact on the way in which all participants, and banking
institutions in particular, can participate in these markets going forward.

The reason behind the heated derivatives discussions is that the $615 trillion over-the-counter market was previously
lightly regulated and, rightly or wrongly, complex derivatives were blamed by many for contributing to the financial
crisis. Most troubling to the populist factions in Congress bent on reforming the industry was the fact that five banks –
Goldman Sachs, Morgan Stanley, JP Morgan Chase, Citigroup and Bank of America – were responsible for over 90
percent of U.S. swaps transactions.

The lawmakers drafting Dodd-Frank responded to the outcry against the derivatives industry by, among other things,
imposing registration and reporting requirements, mandating centralized clearing and exchange trading of most
derivatives, and imposing capital and margin requirements and other business conduct rules. These have been the
headlines of derivatives reform, but another provision – the so-called Lincoln “push-out” provision – will also have a
material impact on the way in which both U.S. and foreign banking organizations operate their swaps desks going
forward.

Named for the Senate Agriculture Committee Chairman Blanche Lincoln, who has been an outspoken critic of banks’
involvement in the risky swaps business, the push-out provision as originally drafted would have forced banks to
entirely spin off their derivatives operations on the reasoning that taxpayers should not have to pay for a banking
institution’s risky behavior.

Not surprisingly, the banking industry balked at the prospect of spinning off their derivatives desks, which have been
amongst the most lucrative businesses for the largest financial companies. Banks argued that pushing out their
swaps desks would have economically disastrous effects. Instead of helping stabilize the economy, it would result in
increased costs which would ultimately be passed on to industry end-users; moreover, it would entail the transfer of a
financial activity from regulated, well-capitalized banks to a less regulated sector of the U.S. economy or, worse, to
London or Hong Kong.

As finally crafted, the push-out provision, which will become effective in July 2013, reflects something of a
compromise, albeit one that will still be a structural hurdle for financial institutions seeking to operate in the most
capital- and cost-efficient way. As finally adopted, the push-out provision prohibits “federal assistance” to any swaps
dealer or other entity with respect to any swap or other activities of the swaps entity. “Federal assistance” includes
any advances from the Fed discount window (other than emergency lending) and FDIC insurance.

As a practical matter, this means that any FDIC-insured bank cannot be a swaps dealer, except to the extent
expressly permitted by the legislation. The prohibition does not apply to an insured depository institution engaged in
hedging or risk mitigation activities directly related to its business. An insured bank is also expressly permitted to
enter into transactions involving derivatives involving rates, currencies or any other “reference assets” that are
permissible assets for national banks, including cleared investment grade credit default swaps. Conversely,
agricultural, metals and energy swaps and non-investment grade CDSs derivatives will have to be moved to non-
bank affiliates. These affiliates will, under Dodd-Frank, be subject to stand-alone capital requirements.

Splitting derivatives operations across separately-capitalized legal entities – one a bank and one not -- will be
challenging, and will raise complicated questions about how, if at all, exposure to the same customers can be netted.
Moreover, another title of Dodd-Frank for the first time expands Section 23A of the Federal Reserve Act to
 

Derivatives Reform: Bank Push-Outs Under Dodd-Frank | By Robin Maxwell and Rebecca Wasserman, Linklaters | August 5, 2010 Page | 1
© Thomson Reuters 2010

     
 
derivatives. Section 23A, which strictly limits the ability of a bank to fund or guarantee the obligations of a non-bank
affiliate (or its customers), will complicate the way in which U.S. banking institutions can fund their swaps activities.

Many of the most significant provisions of Dodd-Frank, including many of the derivatives provisions, were drafted in
great haste mere hours before the House-Senate Conference Committee issued its final report. As expected with any
document written under those circumstances, the final language of the legislation is ambiguous on many points. One
area that remains unclear is how the push-out provision applies to U.S. branches of foreign banks. While U.S. banks
and U.S. branches of foreign banks are both eligible to borrow from the Fed’s discount window (clearly a type of
“federal assistance” within the meaning of the push-out provision), Dodd-Frank’s last minute exemptions for insured
depository institutions did not include a parallel provision for U.S. branches of foreign banks.

On its face, Dodd-Frank thus appears to require any U.S. branch of a foreign bank either to foreswear the right to
borrow from the discount window or to push out all of its derivatives activities. In a July 15 colloquy with Senate
Banking Committee Chairman Christopher Dodd regarding the push-out provision, Senator Lincoln acknowledged
that the omission of uninsured U.S. branches and agencies of international banks from these safe harbor provisions
was unintended, and this inconsistent treatment of banks and branches is expected to be corrected either by a
technical amendment or in the rule-making process

With the political wrangling involved in passing Dodd-Frank behind us, it is difficult to assess whether lawmakers and
bank lobby groups came to a fair compromise on the significantly weakened push-out provision. It is estimated that
$500 trillion of the $615 trillion OTC derivatives market will now be exempt from the prohibition. Additionally, of the
nearly 8,000 banks in the U.S., the push-out provision seriously affects fewer than 25 of them. Fears of the bank
push-outs triggering a wholesale migration of derivatives operations abroad have died down.

Notwithstanding the narrower scope of the provision, the push-out requirement could have a material impact on the
way in which banking institutions structure their U.S. derivatives operations. While a U.S. banking institution can still
engage in the full range of swaps activities by moving these operations to an affiliate, this comes with a price. If a
bank does not already have an affiliate in place, it must set one up, register and separately capitalize it. And although
Section 23A of the Federal Reserve Act will not preclude the bank holding company parent from guaranteeing the
obligations of the new swaps affiliate, it will strictly limit the ability of the insured bank to provide any such guarantee
or other funding.

While Dodd-Frank includes a softer version of the swaps push-out provision than originally expected, it is also not the
last say on derivatives regulation. The legislation explicitly delegates to the SEC and CFTC broad rulemaking
authority over the derivatives provisions in general, and over the relationship between insured banks and swaps
affiliates in particular. As a result, these regulatory agencies will likely further develop the terms of the push-out
provision.

About the Authors

Robin Maxwell is a partner at Linklaters in New York and the head of the U.S. financial regulation group. Her
practice focuses on advising domestic and international banking organizations on a wide variety of bank regulatory
matters, including mergers and acquisitions involving banks and their holding companies, private equity investment in
the banking sector, capital markets transactions, capital adequacy, and bank-sponsored private investment funds.
She has extensive experience with domestic and cross-border bank mergers and acquisitions, joint ventures, and
other strategic combinations.

Robin regularly represents clients before the Federal Reserve Board, the Office of the Comptroller of the Currency,
the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and various state banking regulators.

Rebecca Wasserman is a U.S. associate at Linklaters in New York. She advises domestic and international financial
institutions on U.S. banking laws and regulations. Prior to joining Linklaters, Rebecca was a member of the Financial
Investigations Group at HSBC Bank, and the KYC Group at Barclays Capital, where she primarily focused on
screening new and existing client relationships to ensure compliance with U.S. regulatory and anti-money laundering
requirements.

Derivatives Reform: Bank Push-Outs Under Dodd-Frank | By Robin Maxwell and Rebecca Wasserman, Linklaters | August 5, 2010 Page | 2
© Thomson Reuters 2010

     
 
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Derivatives Reform: Bank Push-Outs Under Dodd-Frank | By Robin Maxwell and Rebecca Wasserman, Linklaters | August 5, 2010 Page | 3
© Thomson Reuters 2010