Sunday, September 13, 2009

Financial Regulatory Reform: the New, Smaller Derivatives Market

One consequence of the regulatory reforms that the Obama administration has proposed will be a smaller derivatives market than existed in the boom years before 2007. We have learned that the derivatives market is inextricably intertwined with the banking system. We've also learned that, instead of ameliorating risk, derivatives exacerbate risk and then concentrate it on a few firms or even one large financial institution (read AIG). After all that, Wall Street firms are still making plans to buy life insurance contracts and package them into asset backed securities. Risk wouldn't be spread out and softened. Instead, investors in the new contracts would simply be gambling on longevity, nothing more or less. Insurance companies and other financial companies wouldn't have their risks reduced; if anything, insurers' risks would grow as policies that historically would have been cancelled by customers no longer needing coverage are bought up and kept in force by investors in the new insurance-backed securities.

The proposals directly addressing derivatives call for the public trading and centralized settlement of standardized derivatives contracts, and increased recordkeeping and reporting for customized derivatives. These measures will help. But they are only some of the steps in the journey.

The final steps in reshaping the derivatives market will come from bank regulatory reform. This is because virtually all the risks in the derivatives market eventually connect back into the banking system one way or another. That's what we've learned with CDOs, CDOs squared and, especially, credit default swaps. The only parties that can play in the derivatives sandbox are the big banks and their counterparties. The big banks will almost always be connected somehow to standardized derivatives contracts (after all, they will capitalize the central clearing agency, and if it faces insolvency, they will have to ride to the rescue because they can't afford to let it go under). And the big banks are the only credible counterparties for customized derivatives. Investors wouldn't buy a customized derivative from anyone else, because anyone else wouldn't be too big to fail and might be unable to honor its obligations under the derivative contract.

Bank regulatory reform includes a couple of measures crucial to the future of the derivatives market. First, bank leverage ratios will be lower. Leverage was a key element to the explosion of the derivatives market in the early 2000s. So a contraction of leverage necessarily means a smaller derivatives market. Second, bank capital requirements will be strengthened and regulators will look askance at special purpose vehicles and other accounting slights of hand that purported, but failed, to shift the risk of loss from derivatives away from the banks. Thus, derivatives exposure will require banks to maintain higher levels of capital without having a convenient potted plant to dump them into. This will raise the cost of doing business in the derivatives market and act to limit the quantity of derivatives outstanding.

Thus, even though no federal regulator will attempt to dictate the quantity of derivatives contracts created or traded, the effect of federal regulatory reform will be to prevent them from reaching the gargantuan levels of yesteryear. This isn't bad. While proponents of derivatives argue that they promote growth, experience tells us that they also heighten the risk of financial crises, which have a notably negative effect on growth. A smaller, kinder, gentler derivatives market could help foster growth, but hopefully at a more sustainable level. We shouldn't fixate on what will produce growth next quarter or even next year. A long term perspective is needed now.

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