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Banks 'dodged a bullet' on derivatives; Financial reform bill watered down during congressional negotiations

Legislation to overhaul financial regulation will help curb risk-taking and boost capital buffers. What it won't do is fundamentally reshape Wall Street's biggest banks or prevent another crisis, analysts said.

A deal reached by members of a House and Senate conference diluted provisions from the tougher Senate bill, limiting rather than prohibiting the ability of federally insured banks to trade derivatives and invest in hedge funds or private equity funds.

Banks "dodged a bullet," said Raj Date, executive director for Cambridge Winter's Center for Financial Institutions Policy and a former Deutsche Bank AG executive. "This has to be a net positive."

Hashed out almost two years after the worst financial crisis since the Great Depression, the legislation shepherded by Senate Banking Committee Chairman Christopher Dodd and House Financial Services Chairman Barney Frank places limits on potentially risky activities such as proprietary trading or over-the-counter derivatives and gives regulators new powers to seize and wind down large, complex institutions if needed.

The overhaul, which still requires approval from the full Congress, won't shrink banks deemed "too big to fail," leaving largely intact a U.S. financial industry dominated by six companies with a combined $9.4 trillion of assets.

The changes also do little to solve the danger posed by leveraged companies reliant on fickle markets for funding, which can evaporate in a panic like the one that spread in late 2008.

The legislation is "largely a fig leaf," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C. "Given where we were when this got started, I'd have to imagine the Wall Street firms are pretty happy."

Banks avoided drastic curbs on their highly profitable derivatives businesses. Lenders including JPMorgan and Citigroup Inc. will be required to move less than 10 percent of the derivatives in their deposit-taking banks to a broker-dealer division during the next two years, which may require additional capital.

Goldman Sachs and Morgan Stanley, which were the two biggest U.S. securities firms before converting to banks in September 2008, won't be as affected because they kept most of their derivatives in their broker-dealer units.

"There's going to be some adaptation, but I don't think there's going to be any colossal impact," said Benjamin Wallace, an analyst at Grimes & Co. in Westborough, Mass., which manages $900 million and holds stakes in Bank of America Corp., JPMorgan and Wells Fargo & Co.

Derivatives rules mean "there's going to be a capital raise, but the analysis we've seen suggests we're talking in the pennies in terms of dilution" of earnings per share, he said.

Senator Blanche Lincoln, a Democrat from Arkansas, had originally advocated forbidding banks that receive federal support such as deposit insurance from trading swaps, a rule that could have required banks to spin off those businesses.

The final agreement provides a number of exemptions: Banks can continue trading derivatives used to hedge their risks and can keep trading interest-rate and foreign-exchange contracts. Banks will have up to two years to move other types of derivatives, such as credit default swaps that aren't standard enough to be cleared through a central counterparty, into a separately capitalized subsidiary.

The rules are "nowhere as bad as what the banks might have feared as recently as a week ago," Bill Winters, the London- based former co-chief executive officer of JPMorgan's investment bank, told Bloomberg Television. "Banks have pretty much factored in already the idea that most derivatives will have to be cleared through a central clearing counterparty. Not a huge surprise and probably not a huge cost either."

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. They include credit-default swaps, which act like insurance for investors in case a debt issuer can't repay.

Swaps sold by American International Group Inc. that later went sour helped push the insurer to the brink of bankruptcy and triggered a $182 billion federal bailout of the New York-based company during the near collapse of the financial system in 2008.

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