Congress' Choice: Real Derivatives Reform Or Another Wall Street Earthquake

This post is an excerpt of testimony presented to the Senate Agriculture Committee on November 18, 2009 in a hearing on legislation reforming regulation of financial markets. The testimony was presented on behalf of Americans for Financial Reform.

When they are properly designed, financial markets play a fundamental role in the resource allocation for our society. Well-functioning markets are an important means to achieve our societal goals. Financial markets, when functioning correctly, serve to aggregate savings and allocate them to productive uses. Financial markets also serve to allocate risk to entities that bear it most comfortably. The system we had in place in recent years, and the one that is still in place as we meet today, has revealed profound flaws.

The Senate Agricultural Committee has, in its history, seen the benefits the derivatives markets can create when they are transparent, have safeguards against manipulation, and restrict excesses of speculation. These markets can provide a powerful resource allocation tool, provide a mechanism to distribute risk and at the same time need not prey upon the resources of civil society.

At the same time, the recent history of unregulated credit default swaps following the passage Commodities Futures Modernization Act that culminated in the failure and bailout of AIG illuminates the danger of potential legislation that does not adhere to basic principles of sound market structure.

Efforts to repair these market structures in light of the diagnosis of the crisis that began in 2007 should, in my view address the elements that caused the crisis. I would suggest that study of the crisis reveals that at the core we have four problems:

1) Excessive leverage
2) Opacity and complexity rather than transparency and simplicity
3) That ability to buy insurance without an insurable risk
4) A misalignment of incentives where the private incentive to take risk exceeds the social desire to bear risk.

Certain types of derivative instruments, their market structures and the associated regulatory structures, have contributed to all of these problems. It is time, in light of experience, for a thorough redesign of these market systems to enhance the real potential of derivative instruments and the repair the obvious flaws in structure have caused so much harm.

Derivative Reform The Centerpiece

Over-the-counter derivatives reforms are, in my view, the centerpiece of the financial reforms that are necessary to address the flaws of our financial system that were revealed by the crisis that began in 2007-8. Derivative instruments are pervasive and their regulation is intimately intertwined with the health of the financial system. The experience of AIG and their exposure to unregulated credit default swaps (CDS) is the most glaring example of the reckless nature of an unregulated derivatives market. CDS buyers in the so-called shadow banking system felt that their purchased protection was a substitute for bank shareholder capital. Yet the writers of the CDS protection, in the case of AIG, did not appear to, and were not required to, set aside adequate capital. As a result, the taxpayer’s capital was extracted to support the counterparties of AIG such as Goldman Sachs and a number of foreign banks who did not pay into any kind of guarantee pool for insurance. This web of connections was considered too dangerous to let fail and it was an example of the hazards of unregulated OTC derivative market breakdown.

The AIG debacle is an important structural episode to learn from, but it is not the only one. Derivatives regulation is not a subject to be treated in isolation. OTC derivative reform impacts all of our financial system’s vital interconnections. It is the very fabric of our financial system.

I believe that the most important dimension of all of the needed financial reforms is the precise intersection between Too Big to Fail financial institutions and OTC unregulated derivatives. This intersection is the equivalent of the San Andreas Fault of our financial system. We are in a new era where the size of the capital markets, and their derivative instruments are a dominant dimension of the intermediation of credit. Derivatives transparency is essential to the safety and soundness of our financial system as a whole and it is essential to the protection of the public treasury. Without OTC derivatives reform enhanced resolution powers for dealing with insolvent institutions could well be rendered impotent and future crises in the credit allocation system will likely be longer and deeper than is necessary.

In recent letters and testimony some end users have emphasized the impact on jobs and the competitiveness of their firms if they were to lose access to customized derivatives and be forced to rely solely upon standardized contracts.

We have a financial architecture in place governing derivatives that has failed profoundly. The bailout costs, lost output around the world, and breathtaking rise in unemployment are the result of that financial failure. When an end user talks about how changing practices in the derivatives market will end up costing jobs at his firm one has to place this in that context. If a dysfunctional derivatives market has led to over use of derivatives throughout the system and has made them too cheap to use because provision for the integrity of the system was not built into the costs, then it is imperative to improve that system architecture and force the end use to incur the costs they rightfully represent that they will experience. The resulting system, fortified and more transparent and well regulated, would reduce the likelihood, and magnitude, of a recurrence of a financial calamity. Not only would society be better off with lower unemployment, but the end user in question would likely experience less disruption to demand for his/her product and not be forced to lay off as many employees in the event of a disruption. Reform would increase jobs and stability of employment in his/her own sector in the larger scheme of things.

We have, in recent years, had a financial system where the private incentive to take risks exceeds the social value of those risky actions. We have subsidized financial speculation indirectly and underpriced insurance by not setting up proper market structures, particularly in the aftermath of the Commodities Futures Modernization Act. When a subsidy is diminished, those who benefit from it are forced to adjust, profits are curtailed, and employment diminished at the margin. Those effects are important to understand, but they do not constitute a reason to refrain from repairing a broken system. Society and the end users are each likely to be better off when the system’s integrity is repaired. The kind of disruptions to commerce we have recently experienced are enormous, dreadful and unnecessary.

In 1970 the automotive industry was at the apex of the world economy. Yet for many years thereafter, as the automotive industry struggled to adjust to the new realities of global commerce, executives from the Big Three spared no effort of time, money or energy to plead with Congress to relax social policy requirements regarding fuel emission standards rather than devoting their energy and resources to R&D directed at improving their products. The result was that together, the auto industry and Congress produced a failure that is all too evident today.

Today Wall Street and the City of London sit at the apex of the economy, not unlike the automotive companies did nearly 40 years ago. It is my hope that our nation will resist “helping” Wall Street adjust in the destructive way they enabled the auto industry to avoid modernization. Wall Street spent many years in public discourse thwarting and resisting the appeals for protection from the declining manufacturing sector. Is it too much to ask them now to practice what they have preached to other sectors of the economy repeatedly? I am confident in the intelligence and vitality of the men and women who work on Wall Street today. They are very able and do not need “Wall Street Protectionism” to survive and to thrive. Would it not be better to inspire them, particularly in light of this crisis, to adapt to a more vital market system rather than to acquiesce to their demands perpetuate a system that protects their profits at the risk of exposing society to a danger to the integrity of our financial system that has caused so much hardship in the present and recent past?

Resisting the demands of Wall Street firms on OTC derivatives reform is easy to agree to, in principle, and difficult to accomplish in practice. Market structures with integrity are a public good. As University of Chicago Professor Luigi Zingales has written recently, “most lobbying is pro-business, in the sense that it promotes interests of existing business, not pro-market, in the sense of fostering truly free and open competition.”

The San Andreas Fault Of the Economy

Wall Street’s leaders cannot control their urge to seek protection despite the fact that it is demeaning to their reputations. Yet the members of this Committee and your counterparts in the Senate are responsible for resisting their demands for the good of society. I do believe that this is no minor matter. The financial security and strength of our nation is in the balance. Confidence in the U.S. dollar as the world’s foremost reserve currency depends upon the integrity of our financial system.

I believe that the intersection between the OTC derivatives market and the large financial institutions is the financial equivalent of the San Andreas fault. Yet there is one difference. The San Andreas fault is a natural occurrence that we must all cope with to mitigate the consequences of an earthquake. It is beyond our power as people to eliminate. The current state of OTC derivatives regulation and its relation to the guarantees of large financial institutions are a man-made fault that is the product of past human errors financial legislation and regulation. It has been revealed by catastrophic events to have devastating consequences. It has produced an avoidable earthquake. That earthquake and its consequences need not be repeated. One can only imagine the consequences for the reputation of those public officials who would choose to act to codify into law this fault line and expose our society to a repetition of the financial crisis that has devastated the world in recent months.

To avoid reform would be harmful enough. We know the fault lines of past human error regarding the regulation of OTC derivatives continue to threaten us. But to affirm the status quo with new legislation that codifies these structural flaws and deems them to be healthy would be far worse. This is not about just leaving a few crumbs on the table for big financial institutions and asking the rest of us to pay a little more. This is about the representative government of our society choosing to affirm a dangerous financial structure that could explosively harm us all again just after we experienced a severe and unnecessary crisis that resulted from these very failures of design.

It would be both dangerous and demoralizing for America and the world if our legislators choose to take that path forward in deference to the parochial desires of a few firms in the financial sector or end users who are clamoring to preserve a subsidy of their risk-mitigation methods.

Views expressed on this page are those of the authors and not necessarily those of Campaign for America's Future or Institute for America's Future