WASHINGTON (CNNMoney.com) -- One of the nation's top banking regulators has taken a swipe at what has become a signature piece of Senate Democrats' Wall Street reform package: cracking down on complex financial products.
Federal Deposit of Insurance Corp. Chair Sheila Bair said she's concerned that the Senate bill goes too far, in a letter sent Friday to the authors of the measure, Sens. Christopher Dodd, D-Conn., and Sen. Blanche Lincoln, D-Ark.
Bair is taking aim at a provision that blocks all banks from trading complex financial contracts called derivatives. The bill would force banks to spin off the desks that trade derivatives, known as swaps desks.
"One unintended outcome of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund, which I know is not the result any of us want," Bair wrote in the letter.
The provision in question is among key controversial hang-ups for lawmakers debating the Wall Street overhaul on the Senate floor this week.
Congress generally wants to get tougher on these complex financial products that are currently traded with no oversight, which were responsible for the taxpayer bailout at American International Group (AIG, Fortune 500). But lawmakers disagree about how much to regulate them.
The measure banning bank swaps goes farther than the so-called Volcker rule, named for former Federal Reserve Chairman Paul Volcker, which only blocks some banks from doing such trades for their own purposes and accounts, called "proprietary trading." The Dodd-Lincoln proposal blocks banks from all derivatives.
In the letter, Bair argued that banks have legitimate uses for derivatives, especially when it comes to locking in an interest rate in their financial dealings. She said that if Congress were to pass the legislation, such trading would continue "but in less regulated and more highly leveraged venues," according to the letter.
Many companies and Wall Street banks use derivatives, whose value is derived from another financial product, to cut the risk that they'll lose money on a deal. Derivatives are also used to lock in the price of a commodity, the way farmers do with the corn they hope to sell after a harvest.
A House bill that passed in December would allow all banks to trade derivatives in a more transparent way. However that bill also allows some trades between some banks and certain companies, such as airlines, to continue without regulation.
But Senate Democrats are tougher on derivatives, in the aftermath of fraud charges that the Securities and Exchange Commission levied against Goldman Sachs (GS, Fortune 500) for selling a complex mortgage-related derivative to investors while failing to tell them that a hedge fund was betting against the product.
The bill says that banks can no longer make such complex financial trades and have access to emergency government-backed loans when they get in trouble.
However, Bair said in the letter that she believes that the Volcker rule goes far enough in accomplishing the same goal, ensuring that taxpayers won't be stuck supporting unnecessarily risky bets.
"To be sure, there are certain activities, such as speculative derivatives trading, that should have no place in banks or bank holding companies," she wrote. "We believe the Volcker rule addresses that issue."
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