Repeal of the “Swaps Push Out” Rule— An Evaluation

[The following post
is contributed by Mandar Kagade, who
is a Policy Analyst at the Bharti Institute of Public Policy, Indian School of
The United States Congress recently passed the Consolidated
and Further Continuing Appropriations Act, 2015
that made headlines for
reasons not at all related to appropriations; it was in the news rather for
including provisions that repealed the so-called “swaps push-out” rule (“Rule”) introduced in the Dodd-Frank
Act, 2010 in the aftermath of the recent financial crisis. Influential members
of the pro-Rule lobby include Nobel Prize winning Economist, Dr. Paul Krugman
(likening the repeal to “revenge of the wall street” in a recent
) and Senator Elizabeth Warren, formerly a law professor at the
Harvard Law School. Understandably, they, including others, have come down
heavily on the repeal of the swaps push out mandate. This post attempts to push
back against such rhetoric and argues that repealing the swaps push out mandate
is likely to lower (not aggravate) systemic risk and moral hazard that the Rule
purported to do.
Briefly, the Rule foreclosed “federal assistance”[1]
to all insured depositary institutions (“Banks”)
that domicile their swap dealing business in the same entity as the Banks. It
permits the Banks to have or establish an affiliate “swap entity” to conduct
swap dealing business. The Rule “safe harbored” a few specified swap dealing
activities – swap dealing for the purposes of hedging and risk mitigation was
permitted, as was dealing in some statutorily defined swaps. Finally, the Rule
permitted Banks to deal in credit derivative swaps subject to the condition
that they be cleared through a central clearing counterparty (to mitigate the
counterparty risk that swap counterparties are exposed to).[2]
On the other hand, the Rule excluded Banks from dealing in structured finance
swaps (having asset backed securities as the underlying for example) and other
non-structured finance swaps that were outside the purview of the relevant safe
harbor statute. The purpose of the Rule was to “ring fence” the speculative
activities of the Bank from the more traditional maturity transformational
intermediation that Banks performed so that excessive risks from the
speculative activities have no spillovers to the broader economy through the
Banks. This is further to ensure that the speculative activities of the Banks
do not benefit from the implicit capital subsidy that Banks enjoy by being part
of the federal deposit insurance system (supervised by the Federal Deposit
Insurance Corporation, FDIC).[3]
Before proceeding further, a word about the repeal provision
is in order: The repeal provision adds to the exemptions already described
above, and permits the Bank to conduct all non-structured and structured
finance swap activities, provided they are, a) for hedging or risk mitigation purposes,
or b) the securities (that are the
underlying of such swap activities) are approved jointly by the relevant
prudential regulators in terms if the type and the credit quality.[4]
As pointed out above, there was a strong push back and
shrill rhetoric arguing against the repeal. The fact that the banking lobby
included the amendment in the unrelated law on federal spending was seen as the
powerful “Wall Street lobby” arm-twisting the Main Street to get its way. Media
reports about certain lobbyists having actually drafted the repeal provisions
augmented the view and proved to be a public relations nightmare for Wall
Street generally.
The politics of the repeal however only reflect the
political economy of financial regulation in the United States. Every time a
financial crisis precipitates, lobbying groups and the politicians advocating
greater regulation use the opportunity to impose extensive regulation—mostly
without adequate cost-benefit analyses. The popular outrage that marks every
expose provides the perfect opportunity to risk monger for political and
“turf-enhancement” purposes. The Dodd-Frank Act, so also the Sarbanes Oxley Act
(that was passed in the aftermath of the Enron scandal) are testimony to this
So, it appears to be a case of double standards to protest when the opposing
lobbying groups succeed in moderating some extreme regulations down the
Politics apart however, criticism of the repeal appears
overstated for the following reasons:
– Contrary to the belief, pushing out
swap dealing to affiliate swap entities is likely to increase systemic risk,
not decrease it. This is because of the fragmented nature of the United States
financial architecture. Under the Rule, Commodity based swaps would be within
the domain of the Commodity and Futures Trading Commission (“CFTC”), and the
Securities & Exchange Commission (“SEC”) had the jurisdiction to regulate
security-based swaps. Banks were permitted to retain a “Swaps Entity” as affiliate,
but such affiliate was mandated to comply with the requirements of either the
CFTC or the SEC as appropriate in addition to the Federal Reserve. Multiple
regulators having jurisdiction over the same/similar financial product can lead
to regulatory arbitrage and let the risk aggregate in the system through
instruments that have laxer regulator. On the other hand, the Federal Reserve
is the sole regulator (backed up by the FDIC intervention in zone of
insolvency) if Banks conduct swap dealing activities on their own balance sheet
and as such no such regulatory  arbitrage
issues exist with respect to its supervision of the Banks’ swap dealing
activities. Further, since the swap activities expose participants to counterparty
risks, prudential regulator like the Federal Reserve that have access to the
entire balance sheet of the Bank appear to be arguably better suited to
regulate the swap dealing activities.
– Finally, since the Rule nonetheless
permitted the Swaps Entity to be an affiliate of Banks, it failed to isolate
the Bank from the systemic risk component that the Swaps Entity was exposed to
while at the same time, making the source of that risk to the Bank one step
removed from its prudential risk regulators. 
In a nutshell, the swaps push out rule had dubious benefits at best.
– On the other side, capitalizing an
entity separately and transferring the technology there entails costs and
smaller/regional banks potentially would not incur the expense of doing so; as
such, their local clientele will be constrained to purchase hedging instruments
from third parties at higher cost than hitherto. Overall therefore, the swaps
push out rule would have made risk management costlier. Further, as
Patrick Bolton has argued
, there are economies of scale and scope in
retaining both the traditional lending and fee-based services (like swaps) in
the same entity that the Banks lose out on, by divorcing the two. For example,
Banks may use the information they obtained through lending to also offer swaps
to a trader-borrower that wants to hedge its commodity exposure for example.
Note that these economies of scale also enable Banks to pass on the savings to
their customers such that the latter are able to hedge their exposure at a much
lower cost. The society as such would have lost out on such gains under the
swaps-push-out framework. 
– A review of testimonies of the then
Chairman, Ben
and FDIC Chair, Ms.
Sheila Bair
reveals that both of them had reservations about the Rule. Ben
Bernanke pointed out that other provisions mandating settlement of OTC
derivatives through a central counterparty, higher margin requirements and
enhanced disclosures are better means to mitigate the build-up of systemic
risks in the system.  In her testimony,
Sheila Bair had pointed out that pushing out swaps activity to an affiliate
will weaken the amount and quality of capital that will be held against the
activity as a prudential measure and put the swap dealing activity beyond the
regulatory supervision of the FDIC.
To summarize, repealing the swaps push out mandate appears
to be a move that will decrease systemic risk than increase it and thus
beneficial to the society rather than the opposite.  It will enable Banks to serve the risk
management needs of their constituents at the same time as enabling the
prudential regulators to supervise and monitor them and prescribe optimum
provisioning requirements against their swap activities, based on their
respective exposures.
Finally, the Congress has delegated the authority to
determine the type and credit quality of the underlying asset backed securities
(against which Banks may write swaps) jointly to the prudential federal
regulators.[6] It
appears that the Big Bank lobby will (again) try and lobby the regulators for
making this permissive universe as wide as possible.[7]
However, the mandate to “jointly” promulgate the type and the credit quality of
the underlying asset backed securities will presumably mitigate the risk of regulatory
capture at the agency rule-making phase.
– Mandar Kagade

Defined widely to include all federal assistance including most notably,
federal deposit insurance to such Banks as conduct both traditional lending and
swap dealing activities in  the same
(bare text of Section 716 that codified the Rule).
Typically, Banks borrow from retail depositors that lend to Banks on demand on
term basis and make loans to corporate and investors that invest the funds in
long-term illiquid projects/ assets. 
This “maturity transformation” exposes Banks to unique risks
(asset-liability mismatch) that may cause their failure in the event the demand
depositors demand their deposits back at the same time. (“Run on the
Bank”).  The federal deposit insurance
scheme mitigates the risk that the retail depositors run on the Bank by
insuring deposits to the extent of USD 100,000 in one person and in one
account. By thus lowering the risk, the federal deposit insurance system lowers
the true cost of capital for the Banks and thus enables them to benefit from an
implicit capital subsidy. This in turn enables the Banks to carry out their
traditional lending operations without worrying too much about the run on the
[4]  See  (bare text of the amendment provisions, “The
Swaps Regulatory Improvement Act”)
See generally, John Coffee, The Political Economy of Dodd-Frank: Why Financial
Reform Tends to be Perpetuated and Systemic Risk Perpetuated, available at,
Supra note 4 at p.4
See Usha Rodriguez, The Political Economy and the Regulatory Sine Curve
available at,

(arguing similarly).

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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