Wednesday, April 21, 2010

Big Banks Love Status Quo, Will Resist Change

Over the past couple of years, we've all been exposed to news reports using arcane financial terms such as derivatives and credit swaps, which are confusing to many people. But they can be pretty easily explained.

Derivatives are simply bets on what will happen in the future. For example, interest rate swaps are bets that rates will either rise or fall. And, for a few hundred years, farmers safely used transparent derivatives contracts to sell their crops in advance.

Derivatives were regulated until 2000, at which point parties were allowed to buy and sell derivatives on bonds without actually owning the bonds. This is analogous to buying insurance on someone else's house, which provides the perverse incentive to then burn down that house.

Through deregulation, banks and hedge funds were no longer compelled to trade derivatives on public exchanges. Suddenly, banks could set derivatives prices and keep them private, without anyone knowing how much risk they were exposed to.

But now proposals are being put forward to clear up the opaque nature of derivatives so that everyone knows what they're based on, who owns them, which ones are being traded, how many are being traded, and what their value really is.

Under one such proposal, derivatives would once again have to be traded on an exchange, just like stocks and bonds. Swaps would have to be reported to regulators and go through a clearinghouse, or brokerage, to make sure that all parties have enough money to cover their deals.

Some groups, such as farmers, airlines, and manufacturers would be exempt, allowing them to continue using derivatives to protect themselves from the wild price swings of commodities.

Another proposal goes even further by requiring banks to spin off their derivatives-trading business or lose their FDIC insurance and access to Federal Reserve credit.

The idea is to prevent banks from engaging in the kind of risky trading that brought the financial sector, and subsequently the US economy, to its knees. Depositors and taxpayers were unfairly put at risk by this sort of gambling.

Re-regulation, the reduction of unsound risk-taking and the protection of taxpayers sounds reasonable, right?

Not to Republicans, who see this proposal as "overly regressive and bureaucratic," in the words of Senator Judd Gregg. They worry that putting derivatives on exchanges would simply move off-shore the type of gambling that nearly destroyed AIG and put taxpayers on the hook to save it.

Banks and other financial institutions fear transparency and want US taxpayers to continue backing their unsound bets. The banker's threats to move off-shore if re-regulated are nothing more than idle threats.

And if some banks refuse to be regulated and do move off-shore, that would be a good thing. If they no longer have FDIC insurance, they will no longer endanger depositors and taxpayers.

Naturally, financial firms are fighting these proposals. They don't like regulation and want the ability to continue doing whatever they choose.

Naturally, the biggest banks, like Goldman Sachs and JP Morgan, don't want to revert to the days when their clients could compare prices for services — the days when trades were transparent. That's not the sort of free market Big Banks like.

Absent transparent pricing, the Big Five derivatives dealers can charge whatever they want for these derivatives products, substantially boosting profits. For example, JP Morgan makes at least $700 million a year through derivatives trading.

This affects more than just farmers. Speculating in the unregulated derivatives market has increased the cost of home heating oil by about a $1 per gallon, according to some estimates.

However, the banking industry is trying to make the case that derivatives are actually good for the economy and that regulating them would somehow decrease lending and credit to consumers and businesses.

Such a suggestion is patently absurd and is designed to scare the ignorant.

Hopefully, not too many of our members of Congress are among them.

Perhaps that's too optimistic.

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