Business Times - 19 May 2009
Financial industry may not accept new rules willingly
By LEON HADAR
THEY have been described as 'exotic financial instruments' and for years most of us were embarrassed to admit that we really did not understand what these Big Shots in Wall Street were talking about. Indeed, while the financial instruments known as derivatives were created as a way of managing risk, they had grown over the last decade into a gigantic market. More importantly, the whiz-kids who invented derivatives used so much jargon that it made it seem like these financial products were a theoretical sub-field of the science of quantum mechanics.
Of course, by now it is safe to say that most of those Americans who have seen their retirement money invested in the stock market evaporate into thin air and who are in danger of losing their homes have become familiar with the risky trade derivatives. They know now that derivatives have grown in a largely unregulated market and have been blamed for igniting the current global financial crisis and the collapse of several large financial institutions, including insurer American International Group and brokerage company Bear Stearns.
Hence, if the Iraq war turned a small and obscure group of intellectuals, the neo-conservatives or 'neocons', into international celebrities and the villains in that foreign policy disaster, the mess in Wall Street and the credit crunch have made derivatives the culprits in the financial crisis. After all, those credit default swaps (CDSs) - paper contracts that amount to bets on whether or not a company that issues a bond is going to default on that bond - were, at one point last year, worth US$62 trillion. Meanwhile, the US GDP is only US$14 trillion!
So, now even free-market enthusiasts, including Wall Street investors, seem to agree with the current conventional wisdom that the federal government needs to regulate this financial version of the Wild West. And, indeed, the Obama administration proposed last week new rules for monitoring and restricting the use of these risky trade derivatives. The ideas the administration is promoting and Congress will start debating in coming weeks include requiring derivatives to be traded publicly on electronic exchanges or a central clearing house; mandating traders and players to put up minimal capital reserves to cover losses; and empowering regulators to demand more information and to crack down on market manipulation.
While many economists and investors agree that derivatives, including CDSs, can play a valuable role by protecting owners of bonds in case of default and therefore make the financial markets more efficient, the problem is that when financial institutions, including banks and insurance companies, start using bets to speculate, buying and selling derivatives like in a huge casino, there is always a chance for big wins - but also huge losses. When a risk-taking individual loses his fortune in Las Vegas, that's his problem. But when the institutions that constitute the US financial system - the ones that are 'too big to fail' - discover that they have made bad bets and lost money, it becomes everyone's problem, since these institutions cannot lend money to consumers and businesses and thus bring the financial system to a grinding halt.
Indeed, when the gamblers' loss becomes a collective problem, or a 'systemic risk', the government needs to enter into the picture and ensure that the nightmare scenario that the American and global economies have experienced in recent months will not happen again. In fact, the federal government will try to apply to the so-called 'shadow banking system' where the derivatives have been traded the same kind of regulation that is being imposed today on the 'official' banking industry as a whole.
It wants to ensure the hedge funds and other entities that engage in that kind of risky business - and are, indeed, too big to fail - will have to regulate their risk, including through greater transparency by ensuring larger capital obligations. The administration and Congress will also have to decide which federal agency will be empowered to apply the new regulations on the derivatives market.
At this stage, there seems to be a bureaucratic competition over the management of the new regulatory system between the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission. However, one must never assume the financial industry will willingly submit to the new regulations.
It is not for nothing that the financial industry makes big contributions to election campaigns and maintains enormous influence over both Republican and Democratic lawmakers. Expect them to use their lobbying power to place major obstacles in the way of new regulations.
Indeed, no one should be surprised when they see the creation of enough legal loopholes to avoid government intrusion and allow parts of the shadow banking system to continue engaging in the kind of risk-taking that could threaten the entire system.
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