Wall Street’s Bad Old Days Could Be Back If the Banks Win this Lawsuit

It’s Wall Street’s latest counterstrike against Washington and its attempts to rein in the financial industry after the crisis that plunged the U.S. economy into recession in 2008. And if the legal attack is successful, it could leave an opening for banks to return to some of the dangerous deals that were a Wall Street hallmark before the crash.

The trade groups, which represent U.S. and international banks, filed a lawsuit Wednesday aimed at one of the central parts of the regulatory overhaul intended to prevent another financial crisis like 2008. It’s the latest step in a long campaign by global banks to push back on stricter U.S. regulation and oversight of trades done in other countries. If a judge agrees with the Wall Street groups, it could spell the end for a central plank of the law meant to curtail risky trading and make the banking system safer.

Wall Street’s chief trade group, the Securities Industry and Financial Markets Association, along with two international trade groups, sued to stop the United States from regulating deals American banks do abroad. In a complaint filed Wednesday, the trade groups ask the court to "halt an unprecedented and unlawful effort" by U.S. regulators to "regulate financial activity around the world."

Regulators have beat back some of Wall Street’s legal challenges, like a suit by Bloomberg LLP over other trading rules. But this suit comes at a vulnerable time. The chief regulator who pushed for the provision is about to step down. If it’s shot down, it’s unlikely to be passed again in the same form.

The lawsuit challenges one of the most controversial aspects of the regulatory overhaul: rules for complex contracts called derivatives. Derivatives are financial contracts linked to the value of something else, like interest rates or currency exchange rates. Companies and financial firms use the contracts to offset risk in their business or to bet on the fluctuating values. After the financial crisis, lawmakers targeted derivatives as an accelerant to the financial crisis and decided to rein in the market with regulations aimed at making it more transparent and less risky.

Derivatives brought insurance giant American International Group to its knees during the financial crisis. Too many derivatives deals souring at the same time nearly killed the insurance giant, but they also linked the failing company to lots of other firms on Wall Street, threatening to bring them all down with it. The U.S. government opted to rescue the insurer, rather than face a possible financial market collapse.

Some of those AIG derivatives deals were done in London. That’s been an oft-repeated talking point for the regulator charged with writing the new derivatives rules, Commodity Futures Trading Commission Chairman Gary Gensler. Gensler has agued that if U.S. regulations don’t apply to U.S. banks and hedge funds doing deals in other countries, you might as well "blow a hole out of the bottom" of the new oversight regime.

Gensler has faced pushback not only from Wall Street lobbyists, but also fellow Democrats and other U.S. regulators. But by far his most vocal critics have been European and Asian officials, who have argued that the United States is overstepping its jurisdiction. Gensler compromised with his critics in July, delaying part of the new regulatory regime, but now he faces a new challenge in court just as he is about to leave the agency at the end of the year.

A spokesman for Mr. Gensler’s agency declined to comment.

U.S. and international banks, through their trade groups, are arguing that the agency is hurting global derivatives markets. The trade groups said regulators were "harming the business relationships of U.S. companies" by "dictating private parties’ obligations through sudden and unpredictable regulatory fiat." Stephen O’Connor, chairman of the International Swaps and Derivatives Association, said on a conference call that the rules would be "harmful to the global economy" because non-U.S. banks will stop doing business with American ones because they don’t want to get roped into the U.S. regulatory system. 

The lawsuit is the latest in a series of challenges to the financial overhaul law, which have targeted rules on everything from mutual funds to the labeling of products that contain minerals from conflict-torn countries. The suits have been successful in some cases and have forced regulators to move more slowly and carefully in rolling out the new rules. But if this challenge is successful, it’ll be the biggest blow yet to the regulator that has moved swiftest in completing its post-crisis rules.