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The swaps pushout is a big deal because financial reform is working

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The government funding bill the House of Representatives passed last week repeals Section 716 of the Dodd-Frank financial regulation bill. That so many influential members of congress were willing to make this a condition for funding the government can certainly make one feel cynical about the state of financial regulation in America. But it's worth understanding that Section 716 repeal is important largely because Dodd-Frank is working.

This was a pretty obscure provision of the law that is a little tangential to its main aims. But it's financially significant for the four large banks who had large quantities of derivatives housed in their bank subsidiaries.

Here the Wall Street Journal's John Carney explains why Citigroup in particular was very interested in this measure:

Citigroup’s insured depository unit is rated A2 by Moody’s ; the parent company is a far lower Baa2. So a bank buying a derivative contract from the parent would receive a higher capital charge than if it bought it from the depository unit. So the price Citi could fetch for it would be lower. The same divergence exists at the other banks, though to a lesser degree.

It's more profitable for Citigroup to have its swaps in its depository unit than elsewhere in the bank because the insured unit is much higher rated than the overall company. That's because the depository unit's debts are insured by the FDIC and the overall company's debts aren't. Which is to say Moody's and the other ratings agencies don't think there would be another huge unconditional bailout if Citigroup were to go bankrupt.

Now Moody's may be wrong about this. The ratings agencies make bad calls all the time.

But the basic reason the swaps pushout issue matters to banks is that the perception is the overall financial regulatory scheme may be working. Investors aren't confident that Citi is "too big to fail" and likely to get future bailouts. That's why Citi wants to get as much business as possible done under the shield of the FDIC.

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