How does this work?
Goldman argues that the highly profitable, tailored segment of the derivative business is unable go on an exchange due to low volumes or pricing difficulty. Alternatively, these high margin OTC products will likely be cleared through a common settlement venue, and based on the current draft of the Senate Bill, would have to be originated outside the bank (Section 1065). This would force banks to move their fixed income derivatives books from the bank subsidiary (that is FDIC protected and has access to the Fed window) to a new separately capitalized (and lower rated) derivatives subsidiary that would likely be guaranteed by the bank holding company. Goldman already operates its OTC fixed income derivatives book out of such a subsidiary and would not have to use new capital to support this subsidiary.
That’s from an enthusiastic “buy” note on Goldman Sachs, penned by Brad Hintz at Bernstein. (Yes, yes, it’s in the usual place.)
Hintz has had a detailed discussion with senior Goldmanites about the bank’s “war gaming” preparations for a reformed financial world. One big area of legislative uncertainty concerns those highly-bespoke, high-margin OTC derivatives that will never fit into a form that can be traded on a centralised exchange – the notorious Section 106.
Both Goldman and the Bernstein man seem to agree that in order to satisfy a proposed regulatory requirement that deposit-taking banks (backstopped by the FDIC) be in future separated from the supposed casino-aspects of finance, institutions like Goldman will set up a structure where both the FDIC-protected bank and the potentially-toxic derivatives business are simply two different subsidiaries of one bank holding company.
The holding company would guarantee the OTC business and the US government would guarantee the bank. Problem solved.
Or not. What seems to have been overlooked here is that the stability of the banking system ultimately depends on confidence, not on legal structures. If and when an OTC trade or any other high risk activity blows up one part of a financial institution, the damage to trust naturally impacts the whole entity, regardless of corporate structure.
You can’t slice and dice confidence – in the same way that we now know you can’t really slice and dice risk.
So are we missing something here, or is the Goldman approach tantamount to giving Volcker, Dodd et al the finger?
That can’t be Goldman’s intention.