|
By Ronald Fink
Yves Smith offers as good an analysis as I’ve seen lately of why breaking up the banks is not enough to prevent systemic risk from re-rearing its ugly head.
Let me put it in more basic terms. Taxpayer funds should be used to help unwind insolvent commercial banks, via the FDIC or a similar institution. But even if investment banking is walled off from that process, it will still pose systemic risk because of the dependence of the credit markets on their trading in derivatives. So derivatives will need to be heavily regulated, and systemically important banks banned from engaging in proprietary trading in them, even if Congress heeds Paul Volcker’s recommendation and restores Glass-Steagall.
In a way, the industry is right about that law being antiquated. The Depression-era regulation cannot keep up with modern finance. But that’s not an argument against resurrecting the divide between investment and commercial banking. Rather, it’s one for not stopping there.
As we report elsewhere today, none of what we see from Congress or the Obama administration goes very far to regulate the derivatives market. Sure, they propose to move some swaps to exchanges, but the fact is doing so is no magic bullet.
The problem is that exchanges can’t clear custom contracts. Additionally, the banking lobby succeeded in gutting a proposal in the House Financial Services Committee to curb the riskiest types, that is, so-called “naked” swaps, where none of the parties have an insurable economic interest in the underlying security or risk the contract is tied to. The lobby also seems to have done the same to another bill in the House Agricultural Committee, though an inquiry we made weeks ago about that to the press office of committee chairman Collin Peterson has gone unanswered.
In fact, naked swaps add tons of risk to the system, because they’re by definition highly leveraged. And there’s no way to hedge that risk without creating moral hazard, through the implicit guarantee that comes from having taxpayers rescue dealers when their bets go bad. Just look at AIG.
As a result, the idea of curbing naked swaps struck us as the most promising regulatory solution of all to the too-big-to-fail problem. Yet as far as we can see, no one on Capitol Hill has adequately explained why it was jettisoned.
Oh sure, you hear bromides left and right about the liquidity added to the market by custom derivatives traded over the counter. But as Bear Stearns, Lehman Brothers, and AIG painfully showed, liquidity is an illusion when there isn’t enough collateral to back a trade. And naked swaps won’t have such collateral unless the parties themselves provide it. That, in turn, is unlikely to happen, unless Congress refuses to make such contracts enforceable in court, as the early versions of banking legislation initially proposed.
It isn’t too late to resurrect the idea, of course, but the chances of that happening seem to grow dimmer by the day. The best hope at this point resides with the Financial Crisis Inquiry Commission. One of its members is Brooksley Born, the former head of the Commodities Futures Trading Commission whose previous warnings about unregulated derivatives went ignored, much to the regret of everyone but the banking industry.
Born told us a few months ago that she favored curbing naked swaps in light of their role in the financial meltdown. Here’s hoping she gets some of her fellow commissioners to join her, and that Congress then listens to what they say.
 |
in In Compliance by 
Subscribe to this comment's feed
