The Swaps Pushout Rule: Much Ado About the Wrong Thing?

A provision of the Dodd-Frank Act popularly known as the “swaps pushout rule” prohibited FDIC-insured banks from entering into certain types of swaps contracts. Congress recently reversed this provision, so that banks can continue trading in these swaps. The reversal provoked an outcry from parties concerned that it would put “taxpayers right back on the hook for bailing out big banks.”[1]

In a new paper, The Swaps Pushout Rule: Much Ado about the Wrong Thing?, we argue that the rule would have done little to protect taxpayers directly from the risks of these transactions. This is because the firms that dominate the swaps market—such as JP Morgan, Goldman Sachs, and Citi—are all bank holding companies (BHCs) that include as subsidiaries banks as well as broker-dealers and other non-bank entities. The rule would have applied only to the FDIC-insured banks, not to any non-bank subsidiaries. In other words, systemically important BHCs (SIBs) could continue transacting in these swaps; the rule merely affected where in the holding company the swaps were to be booked. But because the FDIC has framed its Title II Orderly Liquidation Authority as a resolution of the SIB as a whole, rather than of particular subsidiaries, the rule likely would have had little to no affect on the amount of risk taxpayers faced from this activity.

If a SIB is solvent on a consolidated basis but one of its subsidiaries is in trouble, the SIB will generally step in to support the subsidiary. If, on the other, hand, the SIB is insolvent on a consolidated basis, it will likely be resolved under the new resolution authority created by Title II of the Dodd-Frank Act. Regulators’ current strategy under Title II focuses all resolution activity at the holding company level, so it should not matter where in the holding company losses have arisen. The Federal Reserve is also preparing a new rule that will require SIBs to issue extra loss-absorbing long-term debt at the holding company level, so that losses will fall on private creditors rather than taxpayers. Even if losses outstrip the holding company’s “total loss-absorbing capital,” the likeliest outcome, we argue, is that the government will lend to the faltering SIB, at the holding company level, and recover any losses by imposing a levy on other SIBs.

If the swaps pushout rule did not do as much as its supporters claimed to prevent bailouts, why did banks lobby for its rollback? The biggest reason, we argue, is that under a range of scenarios, new net capital rules for broker-dealers apply a higher charge for the relevant swaps than bank capital rules do. Capital represents a measure of the difference between a bank’s assets and liabilities. The bigger the capital buffer, the less likely a bank will become insolvent. Holding all else equal, however, higher capital also depresses returns on equity. SIB decision-makers therefore like flexibility to book swaps where the capital charge will be lowest.

Those who think prohibition is the appropriate regulatory response to the risk that swaps create for SIBs should recognize the ineffectiveness of the original rule. Effective prohibition would require pushing the swaps out of the holding company family entirely. (This is what the Volcker Rule does for certain types of proprietary trading—it forbids such trading by both banks and bank affiliates.) A different regulatory approach to SIBs’ risky activities is to force them to internalize the risk through capital requirements. The swaps pushout rule would have had the effect of increasing capital requirements on many of the required swaps, but would have achieved this end in a haphazard, inefficient, and opaque manner. If swaps calls for higher capital requirements, regulators should impose such requirements directly.


[1] The rollback was criticized based on process as well as substance: some saw it as evidence of unhealthy influence by big banks. Our focus is exclusively on the substance of the rule and its rollback.

The preceding post comes to us from John Crawford, Associate Professor of Law at UC Hastings College of Law, and Timothy A. Karpoff, Partner at Jenner & Block LLP.  The post is based on their article, which is entitled “The Swaps Pushout Rule: Much Ado About the Wrong Thing?” and available here.