* Banks beg to differ, say exemption too narrow
* They want greater leeway to manage risk
By Alexandra Alper
WASHINGTON, Aug 29 (Reuters) - Banks are urging U.S. authorities to broaden a little-noticed exemption in the Volcker rule's trading curb that critics say could blind regulators to the next version of the JPMorgan Chase & Co Whale trade.
The forthcoming Volcker rule to curb proprietary trading is one of the most hotly debated measures called for in the 2010 Dodd-Frank financial reform law.
Advocates say the rule is needed to make sure banks that receive government backstops like deposit insurance don't make risky bets that could blow up and create the need for a taxpayer bailout. Wall Street has pushed back, saying the rule is too severe and will prevent banks from managing their operations, especially their ability to hedge risk.
At the center of debate are hedging and market-making exemptions tucked into the proposal that regulators issued in October.
Concerns about exemptions grew in May when JPMorgan revealed that a botched hedging strategy had "morphed" into a risky bet at a London unit that was supposed to be balancing the bank's overall credit exposure, costing the bank at least $5.8 billion. The trader was nicknamed the "London Whale" for the giant positions he took.
But another exemption designed to protect banks' ability to manage liquidity risk has mostly escaped the glare.
The exemption covers a special type of account, designed to prevent the kind of cash crunches that took down Bear Stearns and Lehman Brothers in the heat of the 2007-2009 financial crisis.
Banks want an even broader exemption. But critics say the proposed rule, as is, already excludes liquidity trades almost entirely from the Volcker rule, expected to be finalized later this year.
As is, the liquidity exemption "deeply undermines the applicability of the Volcker firewall," Democratic Senator Jeff Merkley, one of the authors of the Dodd-Frank provision authorizing the rule, said in an interview.
Banks, he said, could use the carveout to disguise risky bets that could lead to deep losses like the one created by JPMorgan's now infamous "Whale" trade.
The banking industry is taking a completely opposite view of the exemption, saying it is so narrow that even true liquidity management practices will be caught up in the crackdown.
In a letter to regulators earlier this year, the American Bankers Association and the Clearing House, two major bank lobbying groups, argued that the plan could have the unintended consequence of "undermining the safety and soundness of banking organizations and making the U.S. and global financial systems more vulnerable to liquidity stresses."
Liquidity -- and the lack of it -- played a central role in the financial crisis.
Plunges in the value in the mortgage-backed securities and other real-estate assets shattered market confidence in heavily exposed banks like Lehman Brothers, which were then unable to get the short-term funding they needed to meet obligations.
Even now, regulators are still working to define how much liquidity banks need to withstand a financial panic.
Banks have lobbied regulators to replace the liquidity account exemption with a wider one, which would carve out a broader category of accounts dedicated to "asset liability management," or ALM.
Asset liability management is a bank's strategy for handling any maturity mismatch between assets and liabilities. Foreign exchange, interest rates, and liquidity issues can all drive the mismatch.
Under the proposed rule, banks would have to submit a plan reassuring regulators that the account's securities are highly liquid, aimed at resolving the bank's near-term funding needs, and are not for short-term resale or profit.
JPMorgan, before the trading loss came to light, lobbied for a broader exemption. "The (liquidity) exclusion is so narrow in scope and restrictive in operation that it would not even permit many bona fide liquidity management activities," JPMorgan wrote to regulators in February.
Ina Drew, former head of JPMorgan's Chief Investment Office, which was responsible for the trading loss, met with Federal Reserve officials in February to discuss "the exiting treatment of positions taken for liquidity management purposes," under the Volcker rule proposal, according to the central bank's website.
More recently, a group of regional banks including PNC Financial Services and Capital One Financial specifically brought up the liquidity exemption when responding to a request from House Financial Services Chairman Spencer Bachus for Volcker rule alternatives.
In a letter earlier this month, the banks warned "banks may scale back even traditional lending if associated risks cannot be appropriately hedged."
Mark Jarsulic, chief economist at Better Markets, a reform advocacy group, isn't buying the banks' argument and said the proposal already gives banks too much authority to dictate what trades provide liquidity.
But some banking industry experts say there is some truth in the banks' dire predictions.
"The more tightly you draw (the Volcker rule) to avoid loopholes with regard to liquidity risk management, the harder you make it for banks to control one of the most significant systemic risks," said Karen Petrou, managing partner of Federal Financial Analytics, a Washington-based financial services consulting firm.
Petrou would like to see the exemption maintained, but with fewer requirements to prove that accounts are solely for near-term funding needs. "It is vital that the Volcker rule be crafted in a way that it in no way undermines liquidity risk management."